Private equity is estimated to be less than 2% of all assets managed internationally. It is – at least in theory – an inherently contrarian asset class. But being countercyclical and contrarian is difficult. For illustration, a few days ago I read an article that predicted the ‘denominator effect’ to return. The news was dated April 1st, so I may have been falling for an April Fool’s Day prank. You sense that I have my reservations about the denominator effect – I see it as the blind application of a flawed rule that, in essence, compares apples with oranges. However, it has a strong and ultimately detrimental effect on portfolio management.
Short-term apples and long-term oranges
To recall, maintaining pre-set investment allocation levels is an important part of an institutional investor’s prudential apparatus. For example, guidelines set targets such as 10% allocation to private equity, 20% to hedge funds, 10% to real estate, etc. The problem with enforcing these allocations is that it largely ignores the specificities of illiquid assets – this is where the denominator effect starts to hurt.
During market downturns typically several related events happen. The prices of liquid assets fall and with this the value of the overall portfolio, i.e., the denominator, shrinks. On the other hand the NAVs reported by funds hardly change as write-downs in their valuations lag those of quoted asset classes. As an effect the percentage actually invested in illiquid assets looks much higher than the targeted allocation. Addressing this denominator effect appears to imply selling down some private equity assets, which under what is close to ‘fire sale’ conditions is typically only possible at a substantial loss. Other reactions to such asset allocation problems are improvised and driven by similar ‘tactical’ considerations: occasionally investors, in line with their other assets losing value, aggressively write down their private equity assets in order to maintain their overall asset allocation.
Investors with a long-term focus should have an advantage in private equity, but many increase their allocations to the asset class when it is ‘hot’ and therefore expensive. Reacting to the denominator effect and selling off such assets resembles – to stay with the leitmotiv of this blog – cutting the trees before they bear fruit. Investors throw the principle of a structurally illiquid asset class, where they accepted upfront its illiquidity, over board. They effectively overpay when trying to sell into a secondary market where in this situation buyers hold all power – mainly because their rules state this and everybody is doing it.
A problem that starts at the top
Overwhelmingly the denominator effect is driven by short-term swings in public market that have little to do with the private asset’s true value, but the cyclical investment behaviour and the associated herding spill over. The problem is that private equity valuations do not give signals that are reliable enough early on to allow a rapid and meaningful correction.
Being contrarian may be a virtue, but asset managers are judged against their perceived peers – the pressure to focus on the short term overrides other considerations. Investors follow the example of others, do not rely on their own decision making and are thinking and acting in the same way as the majority around them – the opposite of being contrarian. This essentially is herding and manifests itself in various ways: allocating too much too quickly because the asset class is in a ‘hot’ phase of a cycle, applying portfolio management techniques that work for listed equity but not for illiquid assets, and going for expensive ‘brand GPs’. As John Authers in a recent article in the Financial Times argued, herding ‘is a problem that starts at the top’, i.e., with asset owners themselves – big public and corporate pension plans, central banks, sovereign wealth funds and endowments. The author found this ‘disquieting’ because such investors wield the greatest power and should have the longest time horizon – sovereign wealth funds and endowments virtually infinite.
To add, the larger the institutions are the smaller, relatively speaking, their allocations to alternative assets (see Figure) and for this reason they are also less inclined to put much attention to specificities of what often is perceived to be an ‘exotic’ asset class. Consequently, they tend to follow valuation, performance and risk measurement practices that cater for the bulk of their assets but are flawed in the context of private equity.
Size is the enemy of performance
It is a fair assumption that there is a link between market size and its efficiency. Smaller niches that are under-researched and do not attract material amounts of capital offer the best investment opportunities Right-sizing is one of the central question investors are faced with: large enough to have an impact on the overall portfolio’s returns, small enough to allow access and selectiveness.
The approach followed by large investors is not driven by naivety but rather because they are constrained in several ways. In fact, they are unable to put as much money to work in private equity as part of their allocation to equity as they would like to. Indeed, with increasing assets under management the typical allocation to private equity becomes immaterial (see Figure).
Larger institutional investors are subject to laws of gravity that makes it difficult for them to invest in smaller funds: they necessarily have minimum ticket sizes (in the area of $100m) and do not want to own more than, say, 20% of a fund, which implies minimum fund sizes of $500m. This is also one explanation why these investors rarely commit to venture capital. The crucial difference between the buyout and the venture business derives from the fact that a buyout manager’s skill can be applied to extremely large companies, whereas a VC manager’s skill can add value to few small companies only. The increased scalability for buyout firms allows them to sharply increase the size of their funds, which is not the case for VC firms.
This is accompanied by a high demand for funds managed by ‘brand GPs’ that creates elevated fees and hurts their investors. Most capital is allocated to a limited group of supersized funds that see no need to reduce their fees. While Carlyle’s Rubenstein recently has been calling for private equity firms to accept lower fees, this looks more like pulling up the ladder for those managing smaller funds that do not benefit from scale economies – what makes sense for a vehicle managed by Blackstone, Carlyle and KKR can be nearly impossible for an emerging fund manager in a newly discovered market niche. Unfortunately investors tend to be undifferentiated regarding their approaches. The desire to get into the established and therefore over-subscribed funds is to some degree comparable to the traditional axiom of purchasing agents that ‘nobody ever got fired for buying IBM’.
Hard-code contrarian investing
The key to investment success in private equity is avoiding crowded niches and the associated cycles and not to follow the convoy of large players who are often not the right example. In an IMF working paper Bradley Jones suggested institutionalize countercyclical investment and as the most important step reform governance. Specifically, he questioned the financial literacy of trustees and called for providing them with the training necessary to become better gatekeepers and convincingly argue for contrarian investing. This will be even more necessary for illiquid alternative asset classes, which are usually little understood.
Communication needs to change and de-emphasise short-term performance as much as possible. In the case of private equity this requires a change of valuation and risk measurement practices which are still shoehorned into a ‘risk as market volatility’ framework. As I argued in my previous blog, current financial regulation is of little help here as it tends to focus on such short-term oriented measures.
Most importantly, investment policies need to address contrarian investing and be enforced in order to overcome human biases like exuberance, fear and peer-pressure. Specifically to the denominator effect mentioned before, there is a wide agreement among practitioners that serious investors avoid timing markets. The proven modus operandi is to consistently invest a fixed amount throughout the vintage years, despite the progressive increase in perceived risk, as it essentially gives a countercyclical exposure to the ups and downs of the private equity market. Leave the trees alone and let them grow.
 John Authers, Financial Times, 3. March 2016: ‘Herding is a problem that starts at the top’
 Bradley A. Jones, IMF Working Paper WP/16/38: ‘Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners’