Beware the Private Markets pedestal

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tl;dr: niche strategy allocations to private markets can be great and good managers have opportunities, but be wary of the mounting received wisdom that all private markets are inherently great investments.

One of the clear trends in asset allocation this past decade has been into private markets. You don’t have to look much further than a recent Bain report to see the explosion in the size of private markets investments since 2013.

This has had a few underlying drivers including: bank disintermediation post-08, a stretch for higher expected-returning allocations in the ZIRP era and – maybe- a move away from the public equity markets as a primary capital route for companies earlier in their journey.

I want to talk about a trend I’m seeing which I am quite wary of which is for private markets/illiquid assets to be considered inherently to be a “great” investment and therefore a portfolio must-have, with the only relevant question then being, why aren’t you allocating?

One of my more controversial opinions is that oft-cited illiquidity premium is far scarcer and flakier than commonly thought, but incentives work so that it gets talked up more than it should.

Are private markets always a great investment?

My starting point is that nothing is inherently a great investment you need to show some evidence. As obvious as that might seem I think it’s often ignored. For example, we have 100 years + of evidence for listed stocks, that’s pretty reasonable.

Sure, there have been good investments in private markets, and there might well be in the future (those two things aren’t the same btw), I think private markets probably are inefficient and so can throw up great opportunities. But none of these things are the same as saying that private markets are always inherently great investments. In fact, if the only thing you know for sure about an illiquid asset is that you can’t sell it when you want, then the staring point is kind of the opposite.

I think there’s often a bit of lazy reasoning that goes something like: there sure have been great investments in private markets in the past and …. because folks sure ought to want more returns to lock up capital therefore they will definitely get them … ergo an evergreen illiquidity premium is waved into existence.

Is there a persistent illiquidity premium?

This seems to be one of my more controversial views, but I don’t think there is. I don’t think we reflect enough on how backwards some of the logic is that gets us to the assumption of an illiquidity premium: just because folks ought to want something like extra return for locking up their money does not make it so. I’ll say again, great investments can exist in private markets – and I have happily recommended clients make some investments in private markets, but that is quite different from an assumption that all forms of private markets at all times offer an assured illiquidity premium. It’s a potentially erroneous leap to do that as two Harvard academics carefully laid out in a book: Patient Capital.

Econmically it doesn’t make sense to me that there are huge large-scale seekers of capital out there willing to pay far over the going cost-of-capital in listed markets to place their deals to private market investors (which is what would have to happen for there to be consistently higher returns to investors in private markets). Sure, there are small scale players, real estate lending below certain thresholds, direct lending to small and medium sized companies, that’s all fine, I agree they do exist and can be good investments but those are fairly small niche scale things.

The cost of capital in listed markets has a strong anchoring effect on other markets, it must do because large listed companies (either operating companies like say an Orsted or Vattenfall, a bank, or a block of permenant capital raised on the listed markets like UKW) are never far away as potential buyers and sellers of these assets, and their (listed) cost of capital will drive their propensity to sell or bid for the assets which will impact the price and prospective returns. The idea that large scale private markets can exist in complete isolation from listed markets from a returns standpoint just doesn’t pass the smell test, in my view. What you are more likely to end up with in private markets is listed cost-of-capital type returns, plus leverage, minus fees.

What does the data say?

The Harvard academics I mentioned before sifted the data on private equity and found there has been no consistent premium from private equity over and above public equity markets in the data since at least 2005 (with the possible exception of Venture capital. A recent report from Man Numeric shows the same (when you exclude unrealised gains):

But this isn’t the only issue or even the biggest one …

Now we come to the really big issue with private markets: fees.

Far too often folks identify a return premium and turn around and pay it all away to asset managers. Sounds absurd, but happens all the time. Many modern private markets allocations carry an overall fee load (including fund structuring etc) of 1.5-2%. I don’t think the underlying assets are going to give off 1.5-2% better returns (the assets don’t “know” that you’ve whacked on that kind of fee load, so there’s no economic argument that you get compensated for that).

All this leads to the obvious question of why? Why do private markets get put on an underserving pedestal?

The answer ought to be obvious to any moderatly skeptical industry viewer: fees. If anything public listed markets have become “too good” at matching investors with capital and leaving almost no money on the table for the middle-people in that transaction: asset managers, consultants and the like that form “the industry”. Private markets is the answer to that. Managers and consultants alike can command juicy fees again.

So where you maybe end up with the larger-scale private markets investments is assets that probably don’t really exceed the public markets cost of capital by much if anything, with large fee loads on top meaning the asset owner ends up with less and private markets founders and asset managers fly around in private jets.

Oh, and we haven’t even gotten on to the vagaries of closed ended funds, and how managers will almost inevitably con you with IRRs such that you possibly never actually really know what you returns are, and why every private equity manager boasts a “since inception” IRR of 26% (more on that here, if you’re interested, the 26% since inception does not mean what you think it means)

Why it matters

I do think this is a problem because the “private markets are inherently good” narrative has made it almost all the way into government policy at this point. This is because the funds industry has a very loud lobby voice and many of the arguments seem superficially convincing.

I was part of a conversation the other day where there was a lot of handwringing and furrowed brows asking the question: how can we get more DC funds investing in private markets, and: how can we make it EASIER for DC funds to invest in private markets? Hmmm … indeed how can we better match investors with those that need capital, that’s a good question. I wanted to say: I think you are trying to re-invent the listed stock exchange.

Listed markets have been a fantastically efficient way to match providers of capital with companies and projects that need it. There’s really no need to try and do this artificial end-run around the public markets to force ourselves to invest in a more inefficient way that’s more likely to get us gouged by the industry (there’s a reason that Steven Schwarzman just got paid a billion dollars ).

Again, good opportunities in private markets can exist – generally in niches and specific strategies, but please can we challenge this received wisdom that they are inherently good and all our investors should want more of them?

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