For the past five or so years, I’ve been inundated with pitches from alternative investment managers for private investment funds.
The flagship private market strategy is private equity, which includes private credit, private real estate, and infrastructure. Like public markets, these broad categories can be broken down further, but the basic point is that anything you can get in the public market is also available in the private market.
A lot of the pitch makes sense, and private market investing is a perfectly valid investment approach.
Here are a few examples of the sales pitches for private equity that resonate with me (and there are other good arguments for credit, real estate, etc.):
- Private equity allows for additional diversification because you can own companies that aren’t publicly traded.
- There is some evidence that private equity managers can add value by optimizing the capital structure of a company they own, cutting costs, and offering operational improvements.
- Private equity managers also get more information than public market investors when they buy a company because they sign non-disclosure agreements and get total access to management and the books.
- Private equity managers can access and apply leverage to amplify returns.
- Because private companies are inherently illiquid, a bigger discount should be applied to future cash flows when valuing them, which should translate into a higher expected return.
But there is one part of the pitch that I can’t stand. In fact, I often say at the outset of the meeting, “Don’t bother telling me about the benefits of low volatility or correlation because I think it’s a phony argument.”
I’ve written about this before, but the short recap is that private investments are only priced once a month, quarter, or year. They are priced by third parties hired by private asset managers. There is an arm’s length distance to minimize the conflict of interest, but it no doubt still happens.
Public markets are priced every nanosecond by thousands, if not tens of thousands, of investors. I’m not saying those prices are correct—there is ample evidence that they are too volatile (Shiller et al.) compared to their fundamental value. Still, there is widespread agreement about those prices and abundant evidence that it’s hard to do better than all investors collectively (Fama et al.).
All that discussion is set up to the nonsense I’ve heard from private market salespeople this month: “Our stuff is holding up fine.” Of course, it is: nobody is pricing it!
Again, we can argue whether public market prices are correct. Two weeks ago, stocks were down almost 20 percent from their peak, and now they are down closer to 10 percent, and nothing has changed but investor expectations.
Okay, this is a long setup, but I’ve noticed a good way to show that the low volatility of private markets is baloney (and low correlation, which is a function of the same pricing problem).
Take a look at the publicly traded private markets managers. I found eight US managers with over $10 billion in market capitalization, and I am showing their year-to-date performance in the chart below.
All of them are down between two and 4.5 times the S&P 500. I’m also showing the S&P 500 financials index, which is only down -0.2 percent. Lastly, I’ve included the asset managers, including all the companies I’ve listed above, as well as traditional active managers like T. Rowe Price and Franklin Investments.
The point is that the market can see that the private investments will be marked down at some point, and since these managers charge a percentage of assets under management and a percentage of the profits, they won’t make as much money as a result.
Perhaps the public market is overdoing it, and these declines are too substantial; we don’t know. However, to say that the underlying investments of these managers are necessarily doing better than the public markets is belied by the performance of these publicly traded asset managers.
I want to disclose that I own two of these stocks in my portfolio. I own all of the stocks on our Approved List, and a handful of others, including two here. I’m not recommending them, and you can see from the chart that I’m not too happy with them right now, but I had to say something.
The Investment Committee has heard me say several times that it might make sense to avoid the funds offered by these asset managers and just own them. You don’t get the advantage of the low volatility and correlation (wink, wink!), but you do benefit from the high fees.
Again, I’m not bashing private markets—I think they can make sense and offer good returns. My point is that if you make private investments, do it with your eyes wide open and don’t be fooled by the low volatility/correlation argument.
