Our team of experienced investment consultants at Manager Analysis Services analyzes over 50+ OCIOs for our Outsourced CIO Search and Evaluation services. Private Equity’s (PE) ever-growing share in investors’ portfolios provided a catalyst to ask our OCIO relationships what they are seeing currently. We also have reviewed over 2,000 alternatives managers and we recall a particular review, where a specific manager asserted to have “unlocked the secrets” of private equity performance. Moreover, the manager claimed he could exceed private equity performance using a quantitative small/microcap public equities strategy.
It sure would be nice if this manager’s thesis worked. Investors would have short-term liquidity, rather than face 10-year capital commitments with high fees. Perhaps most compelling would be that small and microcap companies could remain part of the “open and democratic” public markets…one share, one vote…which we would strongly prefer over the current trend of private equity funds subsuming all of microcap into their orbit.
What Are OCIOs Seeing in Private Equity Markets Today?
There is no shortage of challenges in private equity markets today. Private Equity fund raising in 2022 was off nearly 40%, and about 75% in the first quarter of 2023, according to Pitchbook data. The biggest drop has been in Asia with China concerns leading to a decline of nearly 2/3rds in 2022, and near zero fundraising so far in 2023. Concomitant with the decline in fundraising has been a decline in distributions from seasoned private equity funds. Weak public equity markets have slowed the path for private equity fund managers seeking liquidity from IPOs, or acquisitions of their holdings by larger, publicly traded companies. The net result is that the size of the private equity market has not really decreased much from the slowdown in fundraising, and asset owners’ private equity portfolios have experienced decreased turnover.
Private equity valuations have been relatively resilient, but experience demonstrates that private equity valuations tend to lag public market valuations by 6 to 12 months. The public markets’ sharp declines in 2022 caused large PE investors to become overweight (on an allocated basis), and many have reduced or paused additional monies to private equity.
Bright spots and New Opportunities:
In our conversations with OCIO managers, we have heard that:
– The “denominator effect”: Is not impacting all investors. Some have responded by raising their private equity allocation percentages so they could continue their programmatic allocations to private equity managers. Most OCIOs are not concerned about having to raise this allocation percentage, and they encourage investors to sustain their pace of investing in PE to ensure a diversification of vintage years.
– Price Outlook: OCIOs expect more markdowns. With respect to most private equity strategies, markdowns will not be as bad as feared, nor as bad as public equity market declines. Late-stage, venture capital strategies do remain a big area of concern, because those strategies often depend on public market IPOs or buyouts by public companies to provide exits.
– Size: Large, established PE managers are currently more willing to accommodate smaller LPs.
– Fund Sources: Secondary and continuation fund opportunities have grown, offering liquidity to LPs who are overallocated to PE, and interesting opportunities to investors who understand the secondaries markets.
– Financing: Growth opportunities are more appealing; buyout funds are facing much higher financing costs.
Private Equity vs. Public Equity
So why do so many OCIOs like PE? Do PE strategies outperform public equities, and if so, why?
A quick look at the most recently available Pitchbook data on private equity performance shows the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 small cap index, when including dividends. Private Equity funds in the smallest size category materially underperformed but still beat the 12% return of small caps. Overall private equity fund returns beat every major public equity benchmark over the last 10 years ending September 30, 2022.
While PE managers excel at explaining why they “outperform,” let’s take a look at the converse: reasons why their public market-equivalents, microcaps and small caps, tend to underperform private markets.
The Long-Term Assault on Public Equity Markets
American regulators have a practice of creating layers of complexity in reaction to crises, rather than designing and implementing sensible regulatory processes. The US should revisit the regulatory structure for smaller equity issuers, and it should be re-engineered to reflect how smaller public firms can function in a sensible way.
Here are some of the myriad challenges of being a smaller public company, and in some of these cases sensible regulatory reforms could be a big help:
i) High Fixed Costs for Being Public: Not all of our readers may remember the Enron and WorldCom frauds, where both large-cap companies materially exaggerated the scope and profitability of their businesses, yet had a then-big five auditor, Arthur Anderson, conduct and sign off on their audits. Congress’ response was to pass the Sarbanes-Oxley Act [“SOX”], effective in 2003, which created extensive control and testing requirements for publicly traded companies. While the desire for better controls was certainly understandable, SOX reflected regulators’ pattern of throwing additional regulatory burdens on commerce, rather than offering a well-conceived approach to constructing a rational and efficient regulator process.
SOX was a boon to the auditing community, creating an additional ~$1 million in financial statement preparation expenses for every small public company, which posed a heavy burden particularly on microcap companies. Additionally, companies’ CFOs would also be held personally liable for misstatements. The line by which executives could be held personally liable was never very clear, further raising the implicit costs of being a public company.
ii) Scarce Analyst Coverage for Small cap Companies: Small Cap and Microcap executives’ committed substantial energy towards attracting interest from stock analysts and investors. A common thread was that, by not locating sufficient long-term investors who were committed to their investments, the stock price would decline sharply just from lack of focus or interest. Such a decline could render the company vulnerable to activists or takeovers at depressed valuations.
iii) Availability of Growth Equity Capital: If a public company wants to make new investments or acquisitions that require substantial amounts of fresh capital, the company is dependent both on current equity market conditions and market perceptions of it. This contrasts with being able to rely on the perceptions of a smaller set of long-term PE investors who would likely be more receptive to their business plan.
iv) Insider Trading: One way to attract investor interest is to speak with investors about the company’s activities. Some investors would push the limit of these discussions and seek tips or induce a flow of information that would favor their position over other investors with inside information.
v) Market Manipulation around Critical Corporate Events: This topic is too extensive to cover in a briefing, but let’s consider an example of an eminently sensible merger, where Company A is buying Company B at a 50% premium to its stock price and there are no other bidders. The merger arb managers have bought up as much of Company B stock as they can, and it now trades at only a 3% discount to the agreed-upon merger price. To everyone’s surprise, Company B shareholders voted down the merger! How could that happen?
Stock lending desks can sometimes not be careful about who is borrowing the vast amounts of shares available to borrow from institutional custody accounts. Some hedge funds have been known to borrow this stock around the date of record for voting for mergers, while discretely shorting the stock synthetically with over-the-counter swaps. The net result is that the hedge fund had the full voting power of a large shareholder while being heavily short the stock. The hedge fund would induce a sensible merger to fail, and reap outsized profits at the expense of all stakeholders involved.
Risks around the stock-lending process are material, and they are also such a technical niche that corporate management teams, busily focusing on running businesses, are often not prepared for surprises from the stock loan market.
vi) Activist Demands to Pursue Short-Term Gains: To be clear, we like constructive activism, but we are also aware that some activists press companies to make short-term moves that could be viewed as contrary to long-term commitments to a business. We take particular note of news regarding Icahn’s IEP, where this activist seems to be better at extracting short-term gains than actually managing a portfolio of profitable enterprises.
Having analyzed the challenges Small Cap public companies face, let’s look at how Private Equity Markets counteract these challenges and provide investors with an opportunity to consider these markets.
Advantages Offered by Private Equity Markets
Private Equity markets offer Small Cap companies solutions for each of these challenges:
| Public Company Challenge | Private Equity Solution |
| i) High Fixed Cost for Being Public | Private companies face greatly reduced regulatory costs. |
| ii) Scarce Coverage for Small Cap Companies | Private companies can focus on relationships with a much smaller number of private equity managers that specialize in their markets. |
| iii) Availability of Growth Equity Capital | PE managers are receptive to requests for growth capital because they understand companies’ businesses and recognize opportunities. |
| iv) Insider Trading Risks | Generally not relevant, although investors should be cognizant that “continuation fund” offerings can create conflicts of interest between investors seeing their capital being returned at the end of a PE fund’s life, and the general partner seeking to start a new investment vehicle with a lowered high-water mark. |
| v) Market Manipulation Around Critical Corporate Events | The technicalities of stock loan markets are not relevant for private companies. However, private equity investors should understand, analyze, and value any “consulting” or “advisory” agreements between portfolio companies and PE GPs. |
| vi) Activist Demands to Pursue Short-Term Gains | PE managers are heavily incentivized to produce the best long-term returns for investors and can do so by ensuring high quality management teams manage portfolio companies. |
Given the many advantages for companies to be privately held, it should be no surprise to see private equity markets continue to grow. Currently the combined U.S. private equity/venture capital market is about $4.5 trillion. Private real estate, private credit, and private infrastructure represent another $2.3 trillion of private markets. In comparison, U.S. public equity markets are about $51 trillion in size. We view some of the real estate and infrastructure investments as comparable to private equity strategies, and we assess the private equity share of the combined U.S. equity markets as being about 10%.
What should this 10%-share-of-equity-markets mean to institutional investors?
At a minimum, those overlooking this “10%-of-equities” allocation have incomplete portfolios, and they are missing the interesting growth and innovation that historically derives from small and microcap companies. To achieve that allocation, we strongly believe that institutional investors need to develop their PE investing capabilities if they do not already have them.
What about the manager who asserted to have “unlocked the secrets” behind private equity returns, using a quantitative public market strategy?
After about four additional years of performance from this manager, the public markets, and the private markets, the results have been telling. Recalling that the average private equity fund over the 10 years to September 30, 2022 returned an 18% IRR, compared to about 12% for the S&P 600 Small Cap index when including dividends, this manager’s performance has been materially below the S&P 600 small cap index. They marketed a compelling thesis and raised over $500 million, subject to long-term lockups despite the strategy’s relatively liquid holdings allowing much better redemption terms. Moreover, they had outstanding references from notable leaders in the asset management industry.
Why did we recommend the client not invest?
Aside from having unnecessary investor lockups for a small manager in public markets, our concerns were as follows: poor investment thesis through their weak understanding of the PE markets, the convenient omission of the strategy’s poor first year performance from marketing materials, a weak back-testing methodology, flaws in the implementation process, and lack of a sufficiently deep industry experience. We certainly have nothing bad to say about the principals of this manager, but we are pleased to have had the opportunity to redirect our client’s capital to more profitable investments.
Conclusion
We have yet to experience an OCIO manager tell us that the recent challenges in PE markets have caused them to reconsider or reduce their PE allocations in favor of any other asset class. Rather, they see Private Equity continuing to provide an attractive alpha opportunity while diversifying risk in a portfolio:
- Typical OCIO allocations are to be in the 10 – 12% range of equity allocation, and that share continues to grow.
- OCIOs that strongly embrace private markets have private allocations ranging from 25% to 40% where client liquidity profiles allow.
- OCIOs encourage clients to maintain their rate of commitments to PE funds despite 2022 performance and the recent slowdown in PE activity.
- 10 Year PE year returns of 18% are better than both S&P 600 Small Cap Index returns of 12% and other broad equity market indexes.
- PE-owned companies can be better managed, or more inexpensively managed, than public small companies, as they are not subjected to many challenges that public-listed companies face. PE-owned companies have managers that can focus almost exclusively on the direction of their core businesses.
- Any indexing effort to achieve a truly representative allocation to broad equity markets is incomplete if it does not find a vehicle to include a 10% allocation to private equities.
Therefore, we believe that current challenges faced by PE Markets are not signaling any shift into Public Equities. Instead, we see PE markets continuing to take a growing market share within the Small Cap equity markets.
Should you wish to have a complimentary discussion of your private equity investment program, or your OCIO’s investment performance, you can reach us at 917-287-9551, or at cutler@manageranalysis.com.
Manager Analysis Services performs diligence specifically on Private Equity, Venture Capital, and Hedge Fund Managers for investors. We have analyzed over 2,000 funds since our founding in 2003 and we are fully independent. We also offer Outsourced CIO evaluations and searches for Pensions, Endowments, and Foundations. Our 3 Senior Principals have a combined 90+ years in Investments, Diligence, and Risk Management.
