It’s OK to Like Different Things
Ask a CIO #39
I still don't understand why folks commit so much to 10-year+ lockups (with no control) and ongoing capital calls when there is definitely alpha available in more liquid markets? I get direct uncorrelated private investing, but a diversified portfolio of PE/VC funds (where no single position moves the needle and I don't control the asset) doesn't make sense. What am I missing?
I’ve been an active private markets investor throughout my career. I’m consequently a big believer in the potential of private markets to deliver outperformance over public markets. And yet, you might very well not be missing anything.
Does alpha exist in more liquid equity and credit markets? Of course. The more specialized the market, the greater the potential alpha opportunity. There are also myriad strategies to capture that potential public market alpha, whether it be long-only, trading oriented, or something inbetween.
There are many ways to build a portfolio. Investing in private funds is one choice (assuming you meet the qualifications and have access to your desired funds). You’ve fairly pointed out some of the tradeoffs that come with that choice. It is perfectly valid to conclude that the tradeoffs are not worthwhile for you – it doesn’t mean you’re missing anything. It might just mean your priorities are different from those of other investors.
For investors who do choose to invest in private markets, particularly private equity and venture capital, drawdown commitment funds with 10+ year time horizons continue to serve as the predominant investment structure.1 To some extent, if you believe in the asset classes, and you believe it takes skill to execute in these asset classes, then these are the access points.
I’m admittedly a little confused by your comment on direct uncorrelated private investing. I really don’t think the average investor is well suited to rifle shot invest in single individual private assets. Even most sophisticated institutional investors are arguably not set up to pursue direct investments.2
To make my point a little clearer, while also hitting on your criticism of diversified portfolios, let me make a comparison. (And give me some grace here for the analogy. It’s not perfect, but it’s what popped into my head.) Interest in car wash businesses seems to have risen – I’ve seen them in private equity portfolios and have heard individual investors express interest in buying car wash locations. Would you rather own a single car wash location (or 2 or 3)? Or would you rather have a stake in over 200 locations spread out across multiple states? I, and I suspect most investors, would prefer the latter. That said, with over 200 locations, no one location moves the needle, and I wouldn’t have control over the assets. Would I still choose the diversified portfolio? Absolutely.
But wait, there’s more. It turns out, if you’re interested in owning a stake in a private business with that kind of scale, you might need to look into being a private equity investor. Private equity as an asset class is, in many cases, the only way to invest in a surprisingly wide swath of private businesses. And if I had to place a bet, I would take the over on the number of private equity-owned businesses going forward versus today.
I want to pause for a moment on your comment regarding control of assets. With liquid investments, you’re right – you have discretion to buy or sell at your choosing, thereby controlling your exposure. But, absent some specific circumstances (e.g., activist investing, which, by the way, is perhaps not all that liquid), owners of those liquid securities don’t have control of the underlying assets.
Control investments, in which investors have control over the actual assets, or companies, are in fact available almost exclusively through private investments. It is a key part of the private equity investment thesis. Private equity funds, by virtue of owning companies in their entirety, have control over the operations and strategic decisions of those companies. Investors in private equity funds ostensibly believe that those private equity managers can generate alpha through their control ownership. And I would argue, furthermore, this alpha in private markets is more consistent and repeatable compared to alpha in public markets.3
Finally, for investors who do choose to invest in private markets through private funds, it is highly rational to invest in a portfolio of managers. Things happen. Generational transitions don’t always go smoothly. Key person risk is real. Firms are comprised of people, and people make mistakes. These are only some of the reasons underpinning the well-considered advice to maintain manager diversification and vintage year diversification in private investment programs. But yes, it could lead to a diversified portfolio where perhaps no single private company in any private equity fund moves the needle of your larger portfolio.4
With all the above in mind, you might still say, private fund investing makes no sense for your portfolio. And that’s ok! Like I said earlier, there are many ways to build a portfolio.
Thanks for joining this week! And if you have a question, I hope you’ll reach out: askacio@ivyinvest.co.
See you in two weeks,
Wendy
Semi-liquid evergreen structures are increasing in prevalence but still represent a small fraction of all private equity assets. I’m going to set aside semi-liquid funds for this discussion.
I’ve discussed before the challenge of not knowing what you don’t know, if you haven’t had enough reps. The quantity and quality of deal flow matters, and private equity managers unequivocally have higher quantity deal flow and almost certainly have better quality deal flow versus individuals.
To be clear, I’m not disparaging public market managers. I think it’s fair to say that control and locked up capital provide real strategic advantages to generating alpha.
Though some institutional investors who have historically encountered outsized private equity or venture positions in certain companies over the years might beg to differ.