The Rise Of Private Market Investments in Institutional Asset Allocation
What if I offered you an investment that could return 30 times your initial investment in just one month? That’s an annualized return of 36,000%! Sounds too good to be true. How about an investment that would result in the loss of 75% of your initial investment in a single year? Nobody would take that offer. These are outrageous scenarios based on the performance of two publicly traded stocks in 2021, GameStop (GME) and Rivian Automotive (RIVN). While these two stocks do not describe the entire publicly traded market, their stories provide insight into the workings of public equity markets today.
Institutional asset allocators are hired to invest funds in various entities such as university and religious endowments, family trusts, pension funds, sovereign wealth funds, and more. Asset allocators have stewardship over these funds and are required to protect them through careful investment. Public equity markets (“public markets”) pose substantial risks to the mission of these asset allocators. Public markets have become increasingly chaotic. Public market prices have decoupled from fundamental value.
Therefore, actively managed funds that can reliably generate alpha are difficult to find. Lower-middle market private equity provides asset allocators with the antidote to the chaos of public equity markets. Asset allocators should prioritize private market investments because the build-out of a private portfolio takes several years before meaningful cashflows are achieved. It may also take several years to develop meaningful relationships with the best managers, which will be necessary to gain access to the top funds. Selecting alpha-generating asset managers is far more feasible in private and public markets.
Roadmap
This paper will provide background to traditional institutional asset allocators. This background will be followed by an argument about how today’s public markets’ chaos diminishes the capacity for asset allocators to identify alpha-generating asset managers. After that discussion, there will be an analysis of why lower-middle market private equity managers with a partnership philosophy provide an antidote to the chaos of public equity markets. These points will be discussed in four areas: active versus passive investment, the way assets are transacted, volatility, and the opportunity for manager selection.
Institutional Asset Allocators
Institutional asset allocators began to emerge around the beginning of the 20th century. Their typical investments were publicly traded stocks and bonds, i.e., “traditional investments.” This portfolio construction made sense, given the traditional nature of public and private markets. As markets have changed, so too have the strategies of institutional asset allocators. Many firms have begun focusing on private market investments.
Public Equity Market: Chaos
Public markets have become more dangerous for the funds managed by institutional asset allocators as they have developed and transformed. These dangers are principally manifested in the disconnect of prices from fundamental value due to the growth of passive investment, the way investors can buy and sell assets, and volatility, which result in poor opportunities for manager selection by asset allocators.
Active versus Passive Management
Active management is the process by which asset managers research individual companies and industries and make targeted purchases to exploit what they believe to be market inefficiency or mispricing. Passive management would entail purchasing an index of stocks based on a desired industry or thematic exposure, e.g., MSCI ACWI, an index of the global investable public stock market; S&P 500, the largest 500 companies in the U.S. by market cap; and SG CTA, an index of Commodity Trading Advisors. The mandates of active and passive managers are dramatically different. Active managers charge higher fees because they invest significant resources in price discovery, but relatedly, they are expected to generate significantly higher returns. Passive managers charge a small fee to provide investors with a rules-based investment strategy that is minimal in cost but undifferentiated in return, predominantly a market/industry beta strategy. It is widely understood that these active strategies would return, on average, the market return, net of fees. “In 1995, the Russell 1000 passive investors owned less than 5%. As of 2017, passive investors owned nearly half of the market (45%).”
In 1995, less than 5% of the Russell 1000 (an index of the 1000 largest publicly traded companies in the U.S.) was owned by passive investors. As of 2017, however, they owned nearly half of the market (45%). Passive investment makes no effort to discover fundamental value. The dominant position passive investors hold in the market allows for a large decoupling of price and fundamental value.
Asset Transaction
Integral to the growth of passive investment is the liquidity of public markets. Investors can turn assets into cash, and vice versa, instantaneously. There are many benefits to this liquidity. Principally, the ability of markets to price companies according to their fundamental value. As news breaks about company performance and outlook, investors can buy and sell stocks according to their new view of the company’s value. However, the speed at which investors can buy and sell creates problems of its own.
Because investors can buy and sell assets instantaneously, they must also be aware of price changes. Suppose an investor notices an asset’s price is falling. In that case, they will want to sell because they do not have time to evaluate the asset’s fundamental value, but instead, they are more concerned with the loss of principal investment. If the price of an asset is rising, an investor will want to purchase shares of the asset even if they have no view on the intrinsic value because they are interested in participating in the market gains. This phenomenon gave rise to the formal study and practice of momentum investing.
Momentum investing is principally concerned with behavioral finance biases. These biases are what distinguish rational investors from irrational investors. In a survey of behavioral finance literature, University of Chicago professors Barberis and Thaler summarize research about rational and irrational investors. In their work, Barberis and Thaler identify research that suggests “limits to arbitrage,” or the inability of rational, active managers to earn a return through discovering market mispricings when irrational investors create those mispricings. This lends additional credit to the idea that the growth in passive investment has driven a disconnect between price and fundamental value.
Volatility
The primary measure of risk in financial markets is volatility. Volatility is another word for standard deviation or how far an observation is from the mean. Volatility in an investment is undesirable. While higher volatility may theoretically mean an investment has a higher possible return than one with lower volatility, it would also have a lower potential return than one with lower volatility. Additionally, volatility is not normally distributed in the real world. Investments have been observed to have a positive or right skew. This means investments offer investors a rare opportunity to earn significant positive returns and a likelier opportunity to earn small negative returns.
The mismatched relationship between upside—the probability that a stock moves upward—and downside volatility—likelihood that a stock moves downward—is of principal concern to rational investors. The ratio between the downside and upside volatility (“down/up ratio”) provides insight into the balance between risk and return.
Manager Selection
The opportunity to select managers is at the core of an asset allocator’s work. Due to the disconnect of prices from fundamental value demonstrated by the implications of significant rates of passive investment, the results of instantaneous asset transactions, and the down/up volatility ratio, selecting an active manager that can reliably generate returns through the study of fundamental value becomes incredibly difficult, if not impossible. Talented managers may be able to discover intrinsic value through high-quality, bottom-up fundamental analysis. This does not mean they can earn a return from that information. To earn a return, managers must allow markets to price the information the manager has uncovered. As noted earlier, behavioral finance biases limit the ability of skilled managers to extract returns as payment for their price discovery when that information goes against price momentum or irrational price movements.
Lower-Middle Market Private Equity: Antidote
A private market strategy offers itself as an antidote to the chaos of public markets: lower-middle market private equity (“LMM PE”) managers with a partnership philosophy. These firms take an active approach to investing in companies that can be professionalized and grown. Target companies for these firms can be earning anywhere from $5 million–$100 million EBITDA annually. These firms apply expertise and leverage industry networks as they work with portfolio company management to develop real economic growth. The active management alongside the methodical transaction of the assets and the low observed volatility create attractive opportunities for asset allocators to find good managers.
Asset Transaction
Private market assets are illiquid in their nature. They don’t trade at the same speed as public market assets. They exchange hands infrequently and only after a methodical valuation process whereby both parties attempt to understand the asset’s intrinsic value deeply. The parties who transact in private assets differ from those in public markets. Whereas anyone can buy and sell public market assets, typically, only sophisticated, well-informed parties are involved in private market transactions. This means the prices are good reflections of fundamental value. LMM PE managers have done rigorous due diligence to determine what they believe to be a fair price for a company, and company owners have reached out to banks or other sophisticated intermediaries or peers to come to an understanding of how much they could reasonably expect to sell their business for.
Volatility
Due to the low turnover of private assets, current market values are not updated every minute of every business day (like those of public assets). Instead, market values are updated every quarter; this means the observable volatility of private assets is inherently lower than that of public assets. The lower observed volatility may seem insignificant because the theoretical volatility of private and public assets may be the same. However, it can be very significant for institutional asset allocators. The volatility of assets serves as a measure of risk. That risk is what provides an opportunity to earn a return. Because private assets have lower observed risk, asset allocators can take on more income-producing opportunities while staying within portfolio risk limits set by investment mandates or boards of trustees.
Manager Selection
Asset allocators are hired to find asset managers to invest their respective trust funds, endowments, etc. Because private market prices are connected to fundamental value demonstrated by the practice of active management, the sophistication and methodical nature of asset transactions, and the lower volatility—asset allocators can select managers that can be expected to generate positive returns reliably. Provided below are the returns for private equity strategies and public equity strategies. While the distribution of returns is wider for private equity strategies, the top quartile of returns is also higher than the 95th percentile of public equity strategies.
This return distribution is positive for asset allocators. Research suggests that the best private managers have seen persistence in their performance. Asset allocators specialize in identifying good asset managers. As they identify these managers and gain access to the top funds, asset allocators can expect to earn outsized positive returns for their institutions for asset allocators. The superior active management in private strategies gives asset allocators a greater likelihood of finding managers who can outperform. The sophisticated parties involved in the transaction of assets in private markets ensure the prices reflect fundamental value. The lower observed volatility in private markets benefits asset allocators and protects their assets from erratic price swings.
Going Forward in Asset Management
Ultimately, these factors combine to create greater opportunities for manager selection in private markets. Public markets and their chaos pose legitimate threats to the funds that asset allocators are hired to invest. Lower-middle market private equity managers with partnership mentalities provide significant advantages to public market investing. This paper has outlined the relative advantages of private market strategies to public market strategies.
