The Liquidity Cost of Private Equity Investment: Evi … no, wait – please don’t stop reading. We promise this is one of those Value Perspective pieces where we take a worthy if admittedly less than electric-sounding academic paper and show how it highlights an interesting point – albeit not necessarily one the authors intended to make. So you’ll stick with us for a few more paragraphs? You promise? OK …
The Liquidity Cost of Private Equity Investment: Evidence from Secondary Market Transactions sets out to understand “the magnitude and determinants of transaction costs” in the private equity market. Investors do not always find it easy to trade private equity assets at a time that suits them and this illiquidity has led to the development of a secondary market.
Broadly speaking, there are two types of private equity investor – the general partnerships who run the money and the limited partners who have the less demanding but no less vital role of stumping up cash. When you invest in private equity as a limited partner, not only do you buy an asset, you also assume a liability – should the firm managing your asset call on you for cash in the future, you have to pay up.
Since whoever you sell your asset on to needs to be good for these possible future cash demands then, the private equity firm has a say in just who that can be – which of course contributes to the market’s illiquidity. Even so, private equity has become surprisingly liquid in recent years and, as the following chart from the paper shows, saw global secondary transaction volumes of $42bn (£31.6bn) in 2014.
The paper’s authors analysed data from thousands of transactions brokered by a leading intermediary to see what sort of returns private equity buyers and sellers had enjoyed since the turn of the century. One of their findings was that, when sellers sell, it is often for reasons of liquidity – for example, endowment funds during the financial crisis or pension funds in response to legislative changes.
In contrast, most of the buyers in the paper’s sample are funds of funds which, as it points out, are often established “for the explicit purpose of taking advantage of opportunities in the secondary market”. As such, it may not come as a huge surprise to learn that buyers tend to do a great deal better out of private equity than sellers.
Having crunched the numbers on all the cashflows the sellers received up to the point they sold and all the cashflows the buyers received after they bought, the paper found the respective average returns over the period to be 1.3% and 22%. From which one can draw the enticing conclusion that, if you know what you are doing, secondary limited partnership markets can be a great place to go fishing – right?
Well … up to a point, perhaps. One thing to bear in mind here, as we suggested earlier, is that the buyers tend to have excellent timing – or, perhaps more accurately, greater flexibility to choose at which point they make their investment. Furthermore, before getting too excited about private equity, we should really check how returns from the asset class compare with those from public equity markets.
This is something the paper does address – calculating that, compared with publicly-listed equities, private equity buyers were up 2.3% a year while sellers were down 2.6%. Its – arithmetically undeniable – conclusion is that buyers thus outperform sellers by some five percentage points a year but, here on The Value Perspective, we would take something else away from the whole exercise.
That is, for all the extra hoops you have to jump through as a private equity investor – for example, the liquidity issues and the fact you cannot just sell on your investment to whomever you want – an annualised 2.3% extra on listed equities does not seem much of a premium. Especially when you bear in mind that number has yet to factor in any management fees and other transaction costs. There is also the issue of large gains or losses skewing these averages; the median buyer of private equity funds only did 1% better than the public equity markets pre-fees, leading the authors to conclude ‘the median performance is very close to that of public equity markets’.
Here on The Value Perspective we are not anti-private equity – just less convinced of its attractions than some. In Wide of the mark, for example, we suggested an apparent lack of volatility might simply be due to the frequency performance is measured. After all, if you only saw a butterfly fly into and out of a field, you could think it had travelled in a straight line. In reality, of course, the path taken was far less smooth.
Private equity’s admirers will also point to its strong returns and powers of diversification – indeed the ‘Liquidity Cost’ paper observes early on: “Private equity funds provide institutional investors a way to gain exposure to sectors of the economy that they could not without these funds, and consequently add to the diversification of a broad portfolio.”
But does private equity really provide exposure to businesses that are substantially different to listed equities? Granted, there may be different phases in the growth cycle and they may be more levered – undeniably a fantastic source of returns in recent years – but they are still largely cut from the same cloth. Witness the similar nature of the returns – before, of course, you take some very fat fees into account.