{"id":595319,"date":"2023-01-08T05:49:20","date_gmt":"2023-01-08T11:49:20","guid":{"rendered":"https:\/\/news.sellorbuyhomefast.com\/index.php\/2023\/01\/08\/why-does-private-equity-get-to-play-make-believe-with-prices\/"},"modified":"2023-01-08T05:49:20","modified_gmt":"2023-01-08T11:49:20","slug":"why-does-private-equity-get-to-play-make-believe-with-prices","status":"publish","type":"post","link":"https:\/\/newsycanuse.com\/index.php\/2023\/01\/08\/why-does-private-equity-get-to-play-make-believe-with-prices\/","title":{"rendered":"Why Does Private Equity Get to Play Make-Believe with Prices?"},"content":{"rendered":"
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If you wanted to come up with the one-liner about investing most likely to make my head explode, you might try, \u201cThe way to choose investments is to just jump on whatever\u2019s done the best over the past three to five years.\u201d Or, getting more creative: \u201cHey, did you know Cathie Wood is still getting inflows?\u201d Yet more creative: \u201cThe war in Ukraine was caused by stock buybacks<\/a><\/span>.\u201d But you couldn\u2019t do much better than \u201cInterim valuations don\u2019t really matter,\u201d as Christopher Schelling says<\/a><\/span> in reference to private equity investing. If exploding my cranium was the goal, then well played, sir. Otherwise, oh, hell no. <\/p>\n<\/div>\n

Although not alone, I have, IMHO, become one of the <\/span><\/span>chief gadflies<\/a><\/span> of the PE industry. But I\u2019m a selective gadfly. I\u2019m certainly not negative on the whole idea of private investing. Some companies aren\u2019t ready to be public (I\u2019m lumping in venture now). Some need active outside restructuring expertise. Some are just being misvalued by the public markets (more on this later). Private investing serves a vital economic purpose. Furthermore, though to what degree<\/a><\/span> and how much the premium has diminished over time can be debated<\/a><\/span>, there\u2019s little doubt PE has been a historical success (of course, adjusting for factor risk, there are still some cynics<\/a><\/span>). And I live in Greenwich, Connecticut, where the slightly modified clich\u00e9 that \u201csome of my best friends are PE managers\u201d is literally true \u2014 and these men and women know more about how actual companies work than I could ever dream.<\/p>\n

My criticism has been narrowly focused on PE\u2019s lack of mark-to-market valuations and some of the implications this brings. The illiquidity and nonmarking were once implicitly acknowledged, appropriately, as a bug, but are now clearly sold as a feature. The problem is logically you get paid extra expected return for accepting a bug (possibly explaining some of PE\u2019s historical success), but you pay by giving up expected return<\/a><\/span> for being granted a feature. This is a potential problem going forward.<\/p>\n

Let me sum up Schelling\u2019s entire argument: It\u2019s okay not to mark things to market \u2014 it\u2019s even preferred \u2014 as the market is grossly inefficient, with prices that are often wildly wrong, and thus just using PE managers\u2019 own marks is, doggone it, better for everyone.<\/p>\n

Schelling and I actually agree on a lot here. I was never a pure efficient marketer, even in the 1980s when I was Gene Fama\u2019s Ph.D. student (my dissertation on the success of price momentum<\/a><\/span> was a hint!). Living through the tech bubble<\/a><\/span>, the global financial crisis, and the insane<\/a><\/span> trouncing of value stocks from 2018 to 2020 led me to drift even further away from pure market efficiency. I still think markets are the best way for society to allocate capital, but that\u2019s as much about how bad nonmarket alternatives are. So although the issues are complex<\/a><\/span>, I am quite sympathetic to the feeling that sometimes market prices are pretty far away from what\u2019s really justified.<\/p>\n

Of course, in the public markets we don\u2019t get to not tell our investors the current market valuations of our investments just because we think the markets are wrong. In early 2000 (i.e., the tech bubble peak), after losing a ton on long-short value investing, we didn\u2019t tell our clients, \u201cYour money is all still there; it\u2019s just in a bank we call \u2018short the Nasdaq.\u2019\u201d No, we told them, \u201cWe\u2019re down X percent, and here\u2019s why we expect to make back more than X percent when you need it most.\u201d (Narrator: \u201cThey did.\u201d) Yes, I argued this because I thought market prices were wrong. But I didn\u2019t get to play make-believe.<\/p>\n

So why does PE get to? Though some will plead the opposite, it\u2019s not that hard to adjust even private marks in line with the market. If you\u2019re levered long equities (and yep, PE\u2019s \u201clow-risk and low-beta\u201d investments are often levered long) and equities fall by 25 percent, you probably dropped at least that. Perfect estimates are not the point, and shouldn\u2019t be the enemy of good estimates (for instance, some argue<\/a><\/span> private equity betas are near 1.0 even with leverage, but nobody serious argues they are near zero). Sure, sometimes it\u2019s more complicated. But remember, PE managers are among the world\u2019s foremost experts in company valuation. You wouldn\u2019t think the question \u201cApproximately what would we get if we sold in today\u2019s market?\u201d would be particularly tricky for them. That is, of course, if they actually wanted to tell you the answer and if you actually wanted to hear it. It does take two to do the nonmarking tango.<\/p>\n

Many retort, \u201cBut doesn\u2019t the illiquidity leave investors better off long-term, as they act more rationally?\u201d Sure, maybe, sometimes . . . well, actually, it depends. It certainly induces some behavior we advocate in the public markets, such as taking a true long-term perspective. But a few problems emerge.<\/p>\n

First, if investors increasingly value the \u201cPE is easier to stick with as the prices don\u2019t move so much\u201d feature, they\u2019ll invest more and more in PE (sound familiar?), and, as with any asset class or strategy, this can lower future expected returns. Anecdotally (i.e., like you might hear if you got a PE manager a little tipsy on Greenwich Avenue), this is going on through private deal valuations that are higher than they used to be because there are more bidders for the same deal, credit is less investor-friendly than previously (I believe \u201ccovenant light\u201d is the term), etc. Maybe this ain\u2019t David Swensen\u2019s PE market anymore. <\/p>\n

Unlike Swensen\u2019s PE market, which was primarily about earning extra return, today\u2019s PE market is now seemingly as much about not having to report market prices. That kind of investment should return less over the long term than the appropriate levered public equity benchmark (and I haven\u2019t even gone into the fees on fees on fees). Admittedly, this is educated conjecture. The net of the above could be a smaller return premium for private versus public equity, as opposed to a deficit. But I do stand by my conjecture, and though the magnitude is impossible to be precise about, it\u2019s difficult to imagine the drop-off is not directionally right and nontrivial.<\/p>\n

Second, it\u2019s dangerous to understate risk. Many investors use PE to up their overall equity allocations while avoiding the occasional short-term excruciation that accompanies public equity market investing. The only way this increased risk can be justified without simply announcing, \u201cWe\u2019re taking it up a notch<\/a><\/span>\u201d is to assume that this ever-growing PE allocation is relatively low-volatility and low-correlation. You can find many examples of these assumptions \u2014 people like to tweet them at me! \u2014 though whereas some managers are certainly honest or smart enough to avoid them, others lean in, shamelessly bragging<\/a><\/span> that the assets they don\u2019t mark to market outperform in a bear market. Some have taken to calling the understatement of PE risk \u201cvolatility laundering<\/a><\/span>.\u201d Okay, that\u2019s mainly me, but it\u2019s catching on, and volatility as a risk measure<\/a><\/span> more generally gets a bad rap from those who erroneously think it means \u201cshort-term fluctuation that you definitely get back and shouldn\u2019t worry about.\u201d<\/p>\n

Those understated risk assumptions likely become a problem only in a real extended bear market \u2014 not a one-to-three-year bear like we\u2019ve occasionally seen in the past few decades, nor, certainly, a super short crash and rebound like the one in spring 2020. PE can ride those out using its patented ostrich technique (though the GFC was starting to get scary). But say we get an ugly ten-to-20-year bear market, not just \u201cend to end\u201d (like 2000\u20132009, which started out at a bubble peak and ended in a bear market trough, even though both ugly periods were only two-to-three-year affairs). This hasn\u2019t happened in the U.S.<\/a><\/span> in a long time but is well within the realm of possibility. If and when that happens, your starting assumptions of high-single-digit volatility and low correlation to public equity markets for your private, levered equity portfolio will not save you. And what is risk management about if it is not concerned with this low-probability but extreme long-term wealth-destroying outcome?<\/p>\n

Third, doesn\u2019t admitting what you\u2019re doing break the spell? Once you say out loud, \u201cWe know the prices move, but it\u2019s useful to fool ourselves,\u201d doesn\u2019t the fooling yourself part stop working? Well, apparently not! Once you, the investor, admit to yourself, \u201cThis may be levered equity exposure likely offering less versus public markets than in the past, but I\u2019m doing it this private way so I can stick with it long-term,\u201d why on earth can\u2019t you be long-term in public markets? Asking for a friend :-). Okay, I do admit part of my motivation here is professional jealousy. For reasons that obviously escape me, many investors can\u2019t be as long-term in public markets as in private ones, and we in the public markets actually have to live with day-to-day market reality. Heck, I was so jealous I once even took my own shot<\/a><\/span> at marketing a private investment fund. It didn\u2019t catch on.<\/p>\n

But seriously, run the thought experiment where PE managers actually told investors their best guess of what the portfolio could be sold for (not in a panic sale) today. If they did this but still delivered market-beating returns, would all their investors flee? Would the appeal be gone? If so, isn\u2019t that telling? Now run it backward. If a liquid strategy that had a healthy positive long-term expected return was able to report its returns like PE, would the appeal go way up?<\/p>\n

It\u2019s hard to avoid the idea that my confusion over \u201cWhy be long-term only in privates?\u201d is resolved by noting a principal\u2013agent problem where the PE managers get paid a ton so intermediaries can then report unrealistically rosy assumptions and unrealistically calm returns. The chickens come home to roost only if long-term returns no longer beat public markets<\/a><\/span> (i.e., no bear market needed here, just a reversal of the historical illiquidity premium) or, even scarier, a real long-term bear hits and the portfolio\u2019s risk was seriously underestimated. But both parties involved, principal and agent, may be assuming that in ten-plus years that\u2019ll be someone else\u2019s problem. With this bare-knuckles truth-telling, I\u2019m running a real risk of upsetting my clients, many of which have healthy PE allocations. But I am truly trying to help, and, as usual, I will let the chips fall where they may. Truth be told, it\u2019s whoever the agents report to who really need to improve here (i.e., understanding that asset prices actually move and not needing to be fed imaginary unchanging numbers) \u2014 not the agents themselves, who are just responding to incentives.<\/p>\n

Of course, I\u2019m certainly not alone in my worries. For instance, a survey of top academics<\/a><\/span> agrees PE is understating its volatility, and some rather obscure yet somewhat successful active stock pickers<\/a><\/span> seem to agree too.<\/p>\n

So basically, Schelling is right about one important thing. Markets aren\u2019t perfectly efficient, and sometimes they\u2019re grossly inefficient. We both heartily endorse leaning against this in your portfolio while taking a truly long-term perspective, as inefficiencies can be a hard thing to fight short-term. Where we differ: I don\u2019t endorse (1) doing so by making up prices and returns you think are more metaphysically accurate than the market\u2019s current prices; (2) quite possibly today, unlike in the past, accepting a lower expected return on privates versus truly comparable public markets for this volatility-smoothing \u201cfeature\u201d; and (3) seriously understating the true long-term risks to client portfolios if a real long-term bear market hits. I do endorse valuing your portfolio at where you think you could sell it today in a reasonably orderly fashion \u2014 and if you think that\u2019s too low, making that case to your investors, as the rest of us have to do in the real world.<\/p>\n

Given the massive popularity of private investing today, it may very well be true that, as a great man once almost said, \u201cNever have so many paid so much to so few for the privilege of being told so little.\u201d<\/p>\n

\n

Cliff Asness is the co-founder of AQR Capital Management.<\/i><\/p>\n<\/p><\/div>\n

Read More<\/a>
\n Bong Culton<\/p>\n","protected":false},"excerpt":{"rendered":"

If you wanted to come up with the one-liner about investing most likely to make my head explode, you might try, \u201cThe way to choose investments is to just jump on whatever\u2019s done the best over the past three to five years.\u201d Or, getting more creative: \u201cHey, did you know Cathie Wood is still getting<\/p>\n","protected":false},"author":1,"featured_media":595320,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[23181,255,46],"tags":[],"class_list":{"0":"post-595319","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-equity","8":"category-private","9":"category-technology"},"aioseo_notices":[],"_links":{"self":[{"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/posts\/595319","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/comments?post=595319"}],"version-history":[{"count":0,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/posts\/595319\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/media\/595320"}],"wp:attachment":[{"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/media?parent=595319"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/categories?post=595319"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/newsycanuse.com\/index.php\/wp-json\/wp\/v2\/tags?post=595319"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}