The Future of Private Equity
Private equity has had a great run. It’s over. We are in a new world that will drive convergence between public and private equity. That’s actually great news for us allocators, because we will have a broader set of choices and more flexibility in portfolio construction. Fees will probably come down, too.
Private equity has delivered a big return advantage over public equity because of three important structural differences, all of which are set to shrink:
Information. Public companies disclose much more information to investors than do private companies. Investors in private companies have needed a higher return to compensate for this informational disadvantage.
But the information gap between public and private companies is narrowing. GPs are relying more on “big data” tools - analysis of social media, email traffic, and credit card transactions - to identify and vet private companies. At the same time, investors in private equity funds will demand much more timely and granular data on portfolio companies, both to feed more sophisticated “total portfolio” risk models and to make sure that the ESG information on their private equity exposures are equivalent to what’s available in public markets. As technology increasingly erodes the information barrier around private enterprises, LPs will need less of a return premium.
Liquidity. Stakes in private companies have limited liquidity. This also raises their required return versus shares in public companies with daily liquidity.
The liquidity gap is narrowing as well. The volume of secondary transactions (sales of stakes in existing PE funds) has grown at a close to 40% annual rate over the past several years. Recently, the median secondary transaction was taking place at close to the fund NAV. Technology is playing a role here as well with new modeling tools able to analyze fund holdings and provide high-frequency readings on fund valuations. At the same time as private equity is getting more liquid, public equity markets have become less liquid, as the number of exchanges multiplies and high frequency traders dominate liquidity provision. Large blocks are more costly to trade and price impacts greater. There always will be a difference in liquidity between public and private equity, but it will be smaller in the future, especially for larger investors.
Control. Larger investors in public markets can have influence, if not control, over company management. They have the option to increase their stakes, and even take the company over. Private equity LPs have typically had little or no influence over portfolio companies, again driving a need for higher return as compensation.
The control gap will erode as well. GPs are increasingly prioritizing impact investing, engagement, and reporting of ESG metrics. LPs concerned about ESG will demand more engagement with company managements to ensure their concerns are met. Expanded use of co-investment will also give (some) LPs more scope to influence managements. Meanwhile, institutional investors’ influence in public markets is being eroded by the expansion of non- or limited-voting share classes.
This convergence of private and public equity should be a positive for investors and for firms looking to raise capital. The recent WeWork episode demonstrated the value of giving public markets a role in price discovery for private companies before it is too late. Reducing the broad gulf between public and private sources of funding can give firms more flexibility in their financing decisions. And hybrid public/private models could give asset managers more latitude in designing products and offer individual investors access to a wider menu of opportunities.
So how should allocators respond to the convergence of public and private equity?
First, lower your expected return premium for private over public equity. Outperformance of 3% to 5% and more will be replaced with more moderate margins of 1% to 3%. Indeed, excess returns from “private” equity will probably merge with that of high-performing active public equity managers.
Second, don’t let the lower return premium get you down. In large part it will come from reduced relative risk (better information, less illiquidity, more influence) so the risk return trade-off should not suffer. Indeed, some allocators may be able to increase exposure to private markets and improve their overall expected returns without taking more risk.
Third, combine publics and privates in a single equity allocation. Many smart allocators already do this and more will follow as the convergence between public and private equity reveals the growing importance of common return drivers.
Fourth, expect asset managers increasingly to offer hybrid products containing both private and public flavors of equity ownership. Vanguard’s decision to start offering private equity to its institutional clients marks a first step in this journey. Allocators should anticipate this shift and be proactive in ensuring the new products improve transparency and provide fee savings.
Given changes in technology and fierce competition for advantage in capital markets, evolution and change should be the norm, not an exception. The return gap between private and public equity is ripe for arbitrage and disruption. Allocators aware of this coming shift can bring a forward-looking element into their strategies and benefit from it.