The Economist - USA (2020-11-13)

anceforventurecapitalwas39%;forprivatedebt,33%.Forlisted

assets,thebalancewasnegative.Privatemarketsareattheniche

endofassetmanagement.Onlyaround$4trnorsoisinvestedin

privateequity,abouthalfoftotalassetsunderBlackRock’sman-

agementalone.Butprivateassetsarewherethefeesare.Theques-

tioniswhetherperformanceandfeescanbesustained.

Ofseveralinfluencesbehindthegrowinginterestinprivateas-

sets,threestandout.Thefirstistheexampleofsuccessfulpio-

neers.Inthe1980sand1990stheendowmentfundsofa handfulof

bigAmericanuniversitiesshiftedmuchoftheirinvestedfunds

intoprivateassets.ThelargestretirementschemesinCanada,led

bytheOntarioTeachers’PensionPlan(otpp),havea similarap-

proach:runtheplanlikea business,payforgoodin-housefund

managersandinvestinlotsofprivateassets.Thismodelhasbeen

copiedbysovereign-wealthfundsinotherpartsoftheworld.The

intellectualleaderofsuchinvestingwasDavidSwensen,atYale.

He argued that,since life-insurance funds, endowments and

sovereign-wealthfundshaveobligationsstretchingfarintothefu-

ture,theycanaffordtotakea long-termview.Itishardtobere-

wardedfordiligenceinlistedstocks.Privatemarkets,incontrast,

areinefficient.Dataarehardtocomeby,assetsarecomplexand

trickiertoappraiseandwaitingforopportunitiestopayoffre-

quirespatience.Buttherighthomeworkbringsrewards.

Asecondfactorisdisenchantmentwithpublicmarkets.The

age-oldagencyproblemmeansthatinvest-

inginprojectswithanuncertainpayoffcan

be a career risk for managers of a listed

business. It is easier to explain corporate

strategy to a few committed backers than to

lots of shareholders. Founders of technol-

ogy firms who are used to getting their own

way often struggle in the glare of public

markets, and so prefer to stay private for as

long as they can. And the costs and hassle

associated with being a public company

have grown. The Sarbanes-Oxley act,

passed in 2002 in the wake of a slew of cor-

porate scandals in America, introduced

tougher disclosure and financial-reporting

requirements for public companies. The

regulatory requirements on private com-

panies are significantly lighter. And the

National Securities Markets Improvement

Act of 1996 made it easier to set up pools of

private investors. 

A third factor is changes to banking. The

growth of private debt is, in large part, a re-

sponse to the retreat of banks from lending

to midsized businesses and their private-

equity sponsors. Asset managers, starved

of yield in the government-bond markets,

are happy to fill the void. The bigger firms

will even take souring loans off the books

of banks looking to clean up their balance-

sheets. In 2017 pimco, the fixed-income

giant, led a buy-out of €17.7bn ($20bn) of

loans from UniCredit, an Italian bank.

There are likely to be more such deals in

Europe. China is another potential hunt-

ing-ground for distressed debt.

One of the fastest-growing areas of priv-

ate credit is direct lending to companies

which cannot (because they are too small)

or will not (for reasons of confidentiality)

tap the public markets. A private bond

mightbesoldtoonlya handfuloflenders,oreventojustone.Bor-

rowersmayfeelthattheyoughttoknowwhotheircreditorsarebe-

causetheymighthavetorenegotiatewiththem.Thatisthecase

forprivate-equityfirms.Specialistprivate-creditfundsalsooften

prefertobethesolefinanciersofa private-equitybuy-outifthey

likethetermsandjudgethebought-outfirmtobea goodrisk.They

mightevenbethecreditdivisionofa buy-outoutfitthathaslost

thebiddingwarfortheborrowingcompany.

Privatelives

Dotheresultsjustifythehype?Privateequityusesa lotofdebtto

makeitsacquisitions.Onesuspicionisthatallocationtoprivate

equityissimplya wayforpensionfundstogetaroundconstraints

onborrowingtoenhancereturns.Butthebuy-outindustryhasa

decentstorytotelloncapitalallocation.Theacademicliterature

findsthatprivate-equityandventure-capitalfundsmostlyaddop-

erationalnoustobusinesses.Theyinspirebettermanagement

habitsthaninentrepreneur-orfamily-ownedfirms.Buy-outslead

tomodestnetjoblossesbutbigincreasesinjobcreationandde-

struction.Theypromoteefficiencybytakingcapitaloff“sunset”

firmsandputtingit intomorepromising“sunrise”firms.

Andreturns?Assetmanagersareadeptatpresentingstatistics

inthemostfavourablelight.Dudmutualfundsareoftenquietly

mergedorfolded.Managerscanthenclaimthatmostoftheir

The EconomistNovember 14th 2020 Special reportAsset management 9

2

1

Frogs and princes

More and more capital is chasing fewer and fewer ideas

W

ho arethe heirs of Robert Flem-

ing, the 19th-century Scot who saw

that America was the coming place to put

risk capital? The venture capitalists of

Silicon Valley have the best claim. The

businesses that loom largest in public

equity markets—Amazon, Apple, Face-

book, Google, Tesla and the rest—were

nurtured by vcs. Venture-backed com-

panies account for around a fifth of the

market capitalisation of public com-

panies in America and almost half their

research spending. The funds that un-

earth such gems stand to make pots of

money. vcs have on average (an impor-

tant qualifier) beaten the public market

net of fees over the long run.

Most firms that receive vcfunding

fail. But the winner-takes-all nature of

technology markets means those that

succeed often do so extravagantly. The vc

industry is at the frontier of capital allo-

cation. The typical investor has to kiss a

lot of frogs to find a prince (or even a

decent-looking frog). The average vcfirm

screens 200 targets, but makes only four

investments, according to a study in the

Journal of Financial Economics. Part of the

added value, say its authors, is to im-

prove the governance of startups and

keep a watchful eye on management.

No wonder pension schemes, sover-

eign-wealth funds and mutual funds are

competing to write big cheques for Sil-

icon Valley’s next generation of stars. But

unlike the railways, brewers, distillers

and mines of the Fleming era, today’s

new firms have no great need of capital.

A young technology firm can rent com-

puting power from the cloud, download

basic software from the internet and use

a range of cheap, outsourced services to

help it grow. Startups are staying private

for longer. When they list, it is because

the founders need to cash out or (as with

the latest rash of tech ipos) when the

money on offer in the public markets is

simply too good to turn down. It is not to

raise capital for the business.

Very few new firms turn out to be

world-beaters. Good ideas are scarce. But

vcfirms that have succeeded in the past

may have an edge in finding them. A

study by Morten Sorensen finds that

companies funded by more experienced

vcs are more likely to succeed. And

sourcing the best entrepreneurial talent

is more important to success than the

development of that talent.

In this sense the best venture-capital

firms resemble elite universities. Be-

cause the brightest turn up at their door,

they are able to charge the highest fees.

And those fees are mostly for the accredi-

tation and the social networks that the

institution can offer.