Volatility Laundering, Yield Manipulation, and the “False Happiness” of Private Equity

The growing performance gap between public and private markets is a broad topic these days. Investors are often seen as fools who fall in love with “return manipulationfrom shrewd private equity moguls. But what if they are co-conspirators?

That’s what a new paper of three scholars from the University of Florida. Based on nearly two decades of data on private equity real estate funds, Blake Jackson, David Ling and Andy Naranjo conclude that “private equity fund managers manipulate returns to suit the needs of their investors.”

This is not an entirely new suggestion. Academics (and some practitioners) have wondered for years why investors seem willing to pay extra for illiquidity, which is completely contrary to what financial theory and common sense seem to suggest.

For example, a paper 2014 examining the impact of fair value accounting on European private equity found that it increased correlations with public markets and hurt European LBO fundraising. In 2017, the chief investment officer of the Idaho Retirement System apparently called the lack of volatility “false happiness» private markets.

More recently, Clifford Asness of AQR argued in 2019 that “the multi-year illiquidity and price opacity that often comes with it can actually be a feature not a bug” of private capital (Full disclosure: some journalists also wrote about it.) Since then, Asness has campaigned for it to be called “volatility whitening”.

But the findings of Jackson, Ling and Naranjo are more than just a stylized mental model to explain the popularity of private capital. Their main conclusion is that “GPs don’t seem to manipulate mid-performance to fool their LPs, but rather because their LPs want them to.”

Similar to the idea that banks design financial products to cater to investors looking for yield or that companies issue dividends to meet investors’ demand for the payment of dividends, we argue that managers of capital funds -investment reinforce interim performance reports to meet some investors’ demand for manipulated returns.

. . . If a GP increases or smooths returns, perhaps by strategically timing asset acquisitions and disposals or distorting the values ​​of underlying assets, investment managers within LP organizations can flag Sharpe ratios artificially higher, higher alphas and returns, such as IRRs, for their trustees or other overseers. By doing so, these investment managers, whose median tenure of four years often expires years before the ultimate returns of a private equity fund are realized, could improve their internal job security or their potential results on the labor market.

Return manipulations can also produce significant paper wealth for LPs. For US public pension limited partnerships, this may slightly improve funded statuses or change required contribution funding rates. Since private equity returns are often quoted in TRIs, such return manipulations can even permanently mask the end-of-life returns of the private equity fund, potentially protecting LP investment managers. in bad condition.

This likely explains why private equity firms actually averaged 1.6% gains in the first quarter of 2022 and only slight declines since then, as global equities have lost 22% of their value this year.

Just to point out real estate – the main source of data for the University of Florida article – Blackstone’s private property giant BREIT took in $4.2 billion in the third quarter and made a slight gain even as publicly traded REITs lost 12% of their value over the same period.

However, the increasingly abnormal book values ​​of private equity become more difficult to defend when there is an increasingly active market for commercial equity interests in private equity funds. According to Jefferies, a record $57 billion in fund holdings changed hands in the first half of 2022.

Typically, the “secondary” private equity market was where some investors might sell some of one of their investments because their allocations were a bit overweight, they needed to raise money for another investment, or the fund stank and they wanted out. Stakes are therefore usually negotiated at a discount.

In 2019, the thirst for private equity exposure was so immense that some investors would actually pay a premium, but in the first half of 2022, the average holding traded at 86% of the fund’s net asset value, according to Jefferies. And yet, the reported book value of these funds seems remarkably resilient?

This increasingly insane divergence was a big topic in an interesting third-quarter letter to investors from Justin Hughes of Phase 2 Partners, a San Francisco investment firm, that someone kindly sent us.

. . . We recently reviewed a 13-page list of private equity holdings available for sale through a bulge-backed investment bank. Each fund in the 13-page list is available at a discount to the value quoted by the manager. In our view, smoothed returns that rely on model accounting could result in an over-allocation of assets to private markets. We recently sat down with a leading private market manager with an interesting perspective: he believed that private markets are the new “core” asset class as opposed to public markets. Specifically, we wanted to know how their portfolio appeared to be worth a 40% higher EBITDA multiple than public markets.

The company explained to us that these are completely different markets — private markets, the new “core” asset class deserving a premium over their liquid cousin, the public market. Wow, I’m old! I immediately went home, pulled out my latest edition of Ibbotson & Associates: Stock, Bonds, Bills & Inflation and tore up the chapter on liquidity premiums! Starting next month, Phase 2 will release all feedback using the mark to model! I LAUGH!

Maybe investors are just in on the joke, rather than being the target of it?