Low-Frequency Trading

The private equity asset class is both blessed and challenged by its very long holding periods.

If the stock market has a millisecond problem, private equity has a problem measured in decades.

Among its many revelations, Michael Lewis’ new book, “Flash Boys,” highlights the mind-boggling complexity of a mature, traded, technology-dependent asset class. The U. S. stock market has moved so far beyond its origins in human bartering that it now has been taken over by computers that snatch value out of the market in between millisecond trade matches.

Compare this bewildering state of affairs to the less mature, less traded, and technologically under-penetrated private equity market. People aren’t kidding when they say private equity is a long-term asset class. You could commit capital to a private equity fund, raise your kids and send them off to college before getting back the full value of your investment in cash. Perhaps this is as it should be—left to your own fickle decision-making over that roughly 15-year time horizon, you might have stopped investing and missed the prime buying opportunity, desperately sold your best assets in mid-recession, or blown the whole allocation at the top of the market.

Instead, you paid a GP to laboriously deploy the capital over a four-or five-year period, and then remain long-term greedy in deciding when and how to exit those investments. Sell that struggling consumer business in 2010 just because LPs were complaining about needing liquidity? No way. Better to wait it out. That’s called control and optionality. If you need liquidity, sell off your stock portfolio.

In this special report on performance and portfolio management, one of the related measures we examine is DPI, or distributed-to-paid-in capital. That’s the ratio between how many dollars you put into a private equity investment and how many you’ve gotten back. In this report, three experts—Andrea Auerbach of Cambridge Associates, Mike Elio of StepStone, and Kevin Kester of Siguler Guff—examine the DPI of private equity funds launched in 2004. As of Cambridge’s last measurement date, the 2004 vintage funds have an average DPI of 1.02. That’s well behind typical distributions from funds entering their second decade. We can, perhaps, blame the lag on the Great Recession, during which exits were few. But as our gathered experts point out, private equity fundraising rose all the way through 2008. Therefore, a huge amount of private equity’s hoped-for outperformance remains trapped in a collection of portfolio companies of unprecedented aggregate size. As Elio puts it, “If all your gain is still tied up, we have so many assets to liquidate, it’s going to be difficult.”

Secondary “Flash Boys”

It’s clear that new participants in the private equity asset class, armed with decades of such performance data, should know what they’re signing up for—GP relationships that will span well beyond the advertised 10-year life of the individual funds. Investors still concerned about liquidity should also note the increasing size and dexterity of the private equity secondaries market, in which opportunities to trade in and out of partnerships are not quite at “Flash Boys” levels, but are significantly more technologically advanced than even five years ago.

Driving liquidity in the private equity market is the removal of what was one the main impediment to secondaries dealmaking: shame. GPs used to find it embarrassing when LPs wanted out of a fund. Today, this request to trade is now widely accepted and, in many cases, welcomed as an opportunity to forge a relationship with a new investor.

Evidence exists that another psychological barrier to secondaries deal-doing is also fading—the stigma of NAV pricing. In the public market, participants have so many varying views and goals that a stock can find itself priced very differently over the course of an economic cycle. What’s the right price-to-earnings ratio for General Electric? It depends on facts specific to GE and the markets it serves, about which many smart people have different views.

In private equity secondaries land, by contrast, there has historically been a singular focus on pricing around NAV. As in, “Did you pay a premium to NAV or a discount to NAV?” The more a market participant regards NAV as the “true” value of a partnership interest, the more likely they are to believe that buyers are winning if they scoop up a discount and sellers are winning if they command a premium. In lieu of more and better information, NAV pricing is the most important scoreboard. Countless secondaries deals have fallen apart over NAV.

But the NAV is a number assigned by the GP to a collection of private portfolio companies that, while striving for fair value, can credibly vary widely based on the methodology and outlook of the team doing the valuation. The best secondaries investors take a view on underlying portfolio company valuations, not fund-level NAV. Indeed, a recent study conducted by Pantheon’s Rudy Scarpa found that the performance of the firm’s secondaries program had little to do with the depth of discount paid for a bundle of fund interests. Scarpa argues that buyers who focus solely on large discounts to NAV may be encouraging the wrong kind of deal skills.

Increasingly, technology is helping more PE market participants make better decisions around secondaries deals. Platforms that link portfolio data all the way up to limited partners and their advisors bring the asset class a smidgen closer to the symmetry of information that the public market is supposed to provide (repeat—supposed to).

It will be a long time before private equity’s inefficiencies are arbitraged in milliseconds and decimals. In the meantime, advances in liquidity should bring comfort to those who are shocked to discover that the dollar they put in 10 years ago is only now available in full, and who may look longingly at the stock market as an easier, more predictable place to invest.