Do investors receive a premium for illiquidity? It is a fundamental question for private equity investors and one that has got commentators – both PE cheerleaders and sceptics – butting heads.
A spat was kicked off earlier this month by Financial Times columnist Jonathan Ford. Not for the first time, Ford was infuriating private equity folk with a one-sided and incomplete take on private markets. This time he was contesting that, while PE had historically delivered outperformance of 300 basis points compared with public markets (before 2006), the returns since then had been “about the same” as the S&P 500 in the US, with “similar results” in Europe.
His conclusion: investors are getting no compensation for locking their cash up; perhaps they are even doing so willingly to avoid the volatility of liquid investments.
Ford should be given credit for noting that IRR, the go-to metric to show performance versus other asset classes, is less reliable than public market equivalents. However, he doesn’t identify the “large study” that supports his statements in the article, which makes it tricky for readers to assess. He has subsequently told me that it is Demystifying Illiquid Assets: Expected Returns for Private Equity, written by three executives at AQR, a hedge fund.
To the point about relative performance: there is no mention in the article that the period in question includes the longest equities bull market in history. If part of PE’s attraction is how it pulls through a downturn, then measuring it against this window will not show the full picture.
Wellershoff & Partners head of private markets Cyril Demaria weighed in via LinkedIn, urging against judging the performance of unrealised funds. He noted that fully liquidated US and Western European LBO funds had significantly outperformed their public markets equivalents. Net asset values are calculated conservatively, he noted, and thus “NAVs will always trail the index, until assets are sold”.
But as Jos van Gisbergen, senior portfolio manager at Dutch pension Achmea, noted in an email to me: the “pop” in valuation you might expect when an asset is sold at a premium to its book value is also a feature of public assets: takeovers rarely happen at a discount.
Put these questions to a fund manager – as I did this week – and the response tends to be: look at investor behaviour. The smartest investors in the world know exactly how many dollars they have given us and how many they have got back. And those investors are hungry for more private equity exposure; 38 percent of LPs are planning to commit more capital to PE in 2020 than they did in 2019, according to our Perspectives survey.
This is a seductively simple answer, but it discounts the possible effects of herd mentality or any potential vested interests.
For me, the most troubling aspect of this debate is that we are having it at all. It is a weakness of private markets that performance data sets are always incomplete. Sophisticated investors tend to ignore headline performance numbers and request historic cashflow data from prospective GPs, not because they suspect foul play, but because they know headline IRRs and multiples can be calculated in 100 different ways.
As the industry grows, questions about whether it provides value to investors will rightly be asked. Without some sort of standardised performance reporting mechanism, the answers to those questions will remain slippery. That will not be to the industry’s benefit.
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