The Economist - USA (2020-02-01)

62 Finance & economics The EconomistFebruary 1st 2020

2

1

Yet every investment craze is liable to

overreach, blindness to risk and misallo-

cated capital. Recent converts to the private

world, dazzled by the historical returns,

may not fully appreciate the hazards. The

capital washing into San Francisco’s ven-

ture-capital industry has bloated both the

value of pre-ipocompanies and the egos of

founder-managers. The big concern is that

a shift from public to private capital merely

swaps one set of agency conflicts (share-

holders v company managers) for another

(shareholders v private-asset managers).

Where Yale goes the world follows

Private capital was once a fringe interest.

So what changed? The growth in passive in-

vesting has made public markets less com-

fortable for midsized companies. They are

not big or liquid enough to be in baskets of

leading stocks, such as the s&p500 or the

ftse100, that are tracked by giant low-cost

index funds. A generation ago a promising

startup would typically go for an ipowithin

four years. Now the remaining active in-

vestors in public markets are less willing to

take a punt on small firms.

Regulation has played a role, too. Legis-

lation in the mid-1990s made it easier to set

up large pools of private capital in America.

Meanwhile the costs and hassle of being a

public company have grown. After the fi-

nancial crisis of 2007-09 new rules made it

costlier for banks to lend. Even before that,

America’s biggest banks preferred to lend

to consumers and blue-chip firms than to

midsized firms. There was a gap in cor-

porate credit that needed to be filled.

There has also been an intellectual rev-

olution among investors, led by the en-

dowments of large American universities,

which in the 1980s began to devote a grow-

ing share of their funds to private assets.

David Swensen, at Yale, was at the forefront

of this approach. The idea was straight-

forward. Because life-insurance funds,

university endowments and sovereign-

wealth funds have obligations far into the

future, they can take a long-term view.

They can sacrifice the liquidity of public

markets for the better returns promised in

private markets—where data are hard to

come by; where assets are complex and val-

ue is hard to appraise; and where finding

the right opportunities takes patience.

Few investors admit it, but there are

other, sly benefits to private-equity funds.

They can pile on more leverage in order to

boost returns. Some pension schemes and

insurers are forced to sell public shares at

the wrong time, when markets tank, either

to comply with solvency rules or because

trustees panic. That is not possible when

your money is locked up in private funds

with lifespans of a decade.

Since the 1990s a growing band of inves-

tors have followed the Swensen formula

and moved into private markets in order to

capture higher returns. Measuring those

can be tricky. How public companies fare is

no mystery—just check the market prices.

But stakes in private-capital partnerships

are not traded continuously. Data are hard

to collect. Funds do not begin or end at set

times; they have “vintages”. Investors only

really know how they have fared once a

fund is liquidated. Until then managers

have a lot of discretion over how assets are

valued. They are notoriously prone to us-

ing metrics that flatter performance. One

trick is to borrow against equity yet to be

called in the early stages of a buy-out. An-

other is to claim to be a top performer by

picking your best vintage.

Nonetheless the academic literature

has concluded that private equity is not all

smoke and mirrors. A landmark study in

2005 by Steven Kaplan of the University of

Chicago and Antoinette Schoar of mit

introduced a metric called pme(public-

market equivalent) to gauge the merits of

private capital. A recent comprehensive

study based on this technique—by Mr Kap-

lan together with Robert Harris, of the Uni-

versity of Virginia, and Tim Jenkinson of

Oxford’s Saïd Business School—finds that

venture and buy-out funds on average did

better than the s&p 500 index by around 3%

a year after fees. The spread around that av-

erage is considerable. Investors in the top

quartile enjoyed returns that were far high-

er than in public equity; investors in bot-

tom-quartile funds did a lot worse.

Better returns for investors reflect in

large part better operating performance by

the firms that most funds invest in. In the

main, the academic literature finds that

private-equity and venture-capital funds

add value to the firms they own. They raise

efficiency, revenue growth and profitabili-

ty. The firms have better management hab-

its than entrepreneur- or family-owned

firms. Buy-outs lead to modest net job

losses but big increases in both job creation

and destruction. They spur greater effi-

ciency by speeding up exit from low-pro-

ductivity “sunset” firms and entry into

more productive “sunrise” firms. vcback-

ing spurs more innovation, patents and

speedier product launches.

A fledgling business requires lots of at-

tention. Patience and freedom to act are ob-

vious virtues in venture capital. “A startup

is like a sailing boat; it needs to tack quick-

ly,” says Roelof Botha of Sequoia Capital, a

vcfirm. “It is better suited to the private

markets.” In contrast, “a mature company

is like an oil tanker and is better suited to

the public markets.” Mature firms, though,

sometimes need to quickly change direc-

tion too. That is hard to do in the unforgiv-

ing glare of the public markets. Anything

that upsets the predictability of short-term

profits is likely to frighten shareholders.

Private equity can be more patient, because

it has control. “We worry about the quarter-

by-quarter performance only if it is symp-

tomatic of a long-term problem,” says Joe

Baratta of Blackstone.

The boss of a rival firm puts it bluntly. In

private equity there is something called the

100-day plan. It sets short-term priorities

(“quick wins”) for a newly acquired firm,

identifies ways to raise cash quickly (to pay

down the debts raised to acquire the firm)

and plots the longer-term strategy. Ima-

gine a ceo of a public company laying out

such a plan on a conference call to analysts:

“We’re investing in a brand-new it system;

we are putting up for sale the parts of the

business we believe are not vital to our

company; and we have hired some man-

agement consultants to carry out a strate-

gic review of the other parts.” The response

to this would be a run on the stock, he says.

The liberal use of debt juices up head-

line returns but it also helps tame the agen-

cy costs that dog public equity. A hefty in-

terest payment each quarter is a spur to

executives to cut costs and raise revenue.

The bosses hired by private-equity firms to

run companies are made to feel such pres-

sures keenly. These managers are of rela-

Privates on parade

Top four private-equity companies,

assets under management, $trn

Source:Bloomberg

2

1.5

1.0

0.5

0

191817161514132012

KKR

Carlyle Apollo

Blackstone

Wellendowed

Selectedfunds,estimatedassetsinprivatemarkets

2019 orlatest,%oftotal

Sources:Companyreports;TheEconomist

1

Norway Government

Pension Fund

South Korean National

Pension Fund

GIC

BT Pension Fund

AustralianSuper

CalPERS

NY State & Local

Retirement System

CalSTRS

Canada Pension Plan

Investment Board

Yale Endowment

806040200