As global public markets closed out, marred by inflation, political turmoil, and war, forecasts for 2023 were revised. Analysts dim their outlook for the economy. In the face of tough equity markets, family offices and other high-net-worth investors have been increasing their allocations into private equity. The 2022 UBS Global Family Office Report showed increasing interest in private markets, concluding that illiquid assets and investments may diversify against the bad backdrop. And as many family offices in Singapore grow, they have started running their portfolios more like large endowment funds. For example, a Raffles Family Office and Campden Wealth report showed that over a fifth of investments from Asia-Pacific family offices are in private equity, moving closer to Harvard endowment’s allocation of roughly one-third. But is private equity a good investment for anyone who can participate?
Evaluating Private Market Managers
To evaluate a public equity fund, you would look at the current price of the holdings and the fund’s past performance under that manager. You can measure the potential risk of your choice by analysing day-to-day price variations over an extended period. Suppose you believe the fund and its manager will maintain or improve its performance. In that case, you invest—knowing that even if all turns sour, you can sell the position periodically.
The steps are more complicated for private equity managers, but the principle is similar. You start by looking at the manager’s historical performance and existing portfolio.
Historical investments for realised, liquidated funds are the actual cash paid out to investors. You can apply a “Public Market Equivalent” (PME) approach to compare these returns to a public market equity fund by evaluating the fund’s cash flow in comparison to its returns if that cash were invested in a publicly traded stock index instead.
Existing portfolios are more difficult to evaluate as they often have a large proportion of invested capital that is unrealised. As a result, performance is typically based on a valuation that is blessed by accountants. Where applicable, you hope they will have referenced the trading prices of publicly-traded comparable companies and apply a discount for illiquidity. They will also rely on internal models, which consider discounted cash flow analyses and account for deal structure.
Many private investments may give managers options to reduce the price over time with some conditions, priority over other investors, or even debt-like features. For example, the University of California recently injected US$4 billion into Blackstone’s private real estate fund, which had faced a wave of investor withdrawals. This is under the condition that the University of California receives some guaranteed returns in exchange for holding the investment for six years.
But perhaps the most difficult is understanding the risks in the existing portfolio’s mark-to-market values. There are big implications. For example, EnCap’s private equity manager valued its investment in Southland Royalty oil and gas company at over US$770 million in September 2019 but suddenly wrote it down to zero a few months later. In more recent drama, Singapore’s Temasek’s investment in FTX was suddenly written down to zero at the end of 2022 as the cryptocurrency exchange was revealed to have stolen and lost billions in customer funds.
Therefore, the reported accounting returns typically look smoother than public counterparts but with more jumps up and down. For this reason, public market fund managers lament that this illiquidity also means private equity managers get to hide behind their underlying risks.
But are private equity fund positions less risky than public equity funds at any given time? No. The illusion is due to existing account rules, which differ greatly by whether a private equity manager is a venture capital firm or another type of business. For example, in response to the Global Financial Crisis in 2008, the United States Financial Accounting Standards (FAS) rule 157 defines how companies use fair-value accounting. However, other rules like FAS 159 allow for some flexibility. Notably, the focus was on leveraged buyout funds and not venture capital.
Professor Jeffrey Hooke, who wrote the book “The Private Equity Myth,” once said that both investors and managers mythically believe that “the returns are a lot smoother than they are in actuality, and it benefits the investors because they don’t have to show the big markdown on that presumably.” Indeed, Harvard Endowment’s 2022 report stated that its highest-risk asset classes, including private portfolios of venture capital, buyout, and real estate, were the strongest performers. However, Harvard’s non-marked-to-market valuations may mean the reported returns are biased.
The differing accounting rules generate a trade-off for investors between the investment structure and the public-private information barrier. On the one hand, the capital commitments by investors allow private equity managers to take longer-term bets that are more lucrative. On the other hand, if performance deteriorates, investors cannot pull out their investments.
The challenge is deciding whether the current returns presented by a private equity fund, which naturally incorporate valuations and volatility of existing, unrealised positions, represent the investment’s true (potential) performance.
Private Banker Recommendations
Many eligible investors would likely have been recommended more private equity vehicles recently, perhaps as part of the 2023 investment outlook and reporting. But before following their advice blindly, it is also worth noting that, especially in Asia, even licensed financial advisers are not required to act in the best interest of their clients. Apart from charging investors a 5 per cent sales fee for moving investments around, many financial advisers also demand and receive trailer fees from investment managers for selling the fund.
Against this backdrop, it should not be so surprising that when public markets perform poorly, financial advisers recommend more illiquid, less transparent investment vehicles for which they may still collect meaningful fees and kickbacks.
These caveats are important to keep in mind. Following a bull market for technology companies, the stratospheric valuations of these firms in public markets are coming down. As a result, the portfolio companies of venture capital firms may soon need to raise equity at much lower valuations—inviting potentially large write-downs.
What Do Big Players Do?
The good news is that private versus public market investment is not an either-or decision, and investors can learn from large institutional investors. Although their goals differ, large endowments can provide insights into how to view risk assets from a long-term perspective.
Institutional allocators are tasked with investing large amounts of capital across all asset classes and are major investors in private equity. On the lower end, public pension funds historically have allocated only 8 percent of their portfolio to private markets, including private equity. Endowments and foundations are higher, averaging 12 percent. However, there are still large variations, as notably Harvard and Yale adopt larger private equity allocations.
Endowments and pension funds maintain smaller private equity allocations than public equity for a reason. First, there is a wide dispersion of private fund performance. Second, and more importantly, manager selection is a challenging, lengthy process. Apart from the steps above in measuring performance, institutional investors with large investment teams perform in-depth due diligence and extensive interviews with the fund managers to assess the team’s quality and strategy.
Institutional investors seek to build a long-term, multi-fund relationship with a manager. However, most smaller family offices do not have such relationships, making their relative overweight of private equity slightly concerning. In particular, the recent trend of increased access to private market investing by enticing less specialised and sophisticated investors may cause dislocations in the market. This influx of capital affects all participants. Less informed capital flows may dislodge the competition among private market managers and the pricing of potential portfolio companies.
Entering the Private Markets
Individual family offices now have more access to direct stakes in private companies or positions in larger private equity funds through private banks, digital exchanges, or private market platforms. These family offices must take great care to avoid trend-following and identify the incentives of the access channel. Brokers and distributors who charge high fees and hold little to no long-term stake in performance are prevalent.
Even if you find a good private equity fund, most people likely cannot invest in it because it is closed. Although you may have the opportunity to participate in a secondary purchase from another investor, options to do so are limited and costly for most investors. Fund performance may also vary according to different economic conditions. In addition, smaller investors often do not get access to the best private equity fund managers or cannot continue investing with them.
Nevertheless, private equity as an asset class seems to have delivered realised returns slightly higher returns than public markets. One way they do that is by being able to control or have substantial influence over a company’s operations. This feature, along with the deal structure, can genuinely reduce the investment risk of a portfolio company.
We should admit that the last few years have been extraordinary for both public and private capital markets. As a result, there will be buying opportunities even in tough market conditions. The burden, however, is on the potential investor. A family office, or their advisor(s), must develop the requisite skills and access to information to make objective assessments.
By Ben Charoenwong, Ph.D
