Patient capital is critical in public equities too

Produced in partnership with Loomis, Sayles & Company, an affiliate of Natixis Investment Managers.

Any asset class can be made to look good by cherry-picking time horizons and benchmarks and using subjective valuations.

So when comparing different asset classes, investors and advisers need to ensure that they are judging like for like.

This is especially true for public versus private equity, which are often pitted against each other given both are fundamentally buying and selling shares in companies and have the same goals and risk characteristics. Still, the measurement framework for investing in public equities differs significantly to the framework for investing in private equity, making comparisons “unhealthy and unhelpful”, according to Aziz Hamzaogullari,founder and chief investment officer of the growth equity strategies team at Loomis, Sayles & Company.

“The current framework is much more patient for private equity and that has led to this idea that it’s easier to make money in private equity even though the dispersion among private equity managers’ performance is much wider,” he says.

When it comes to private markets, there is a general acceptance that managers require longer time horizons of at least five-to-ten years to deliver a return on investment while public equity managers are more typically judged on their three-year numbers.

In private equity, investors generally believe there is an illiquidity premium to be gained from locking funds up for a lengthy period of time, despite the fact public markets in aggregate have outperformed over the past 15 years.

The impatience of public equity investors and the often-detrimental implications is highlighted in a 2008 study by Amit Goyal and Sunil Wahal on how investment decisions are made.

The study, which examined the hiring and firing of external fund managers by institutional investors, found that investors commonly participated in a “self-defeating cycle of manager churning” by hiring managers that had strong three-year performance numbers and firing those that underperformed over a rolling three-year period.

Not only did this add unnecessary transition costs of 1-2 per cent for no benefit, but sacked managers typically outperformed by over 100 basis points in the ensuing three years.

A 32-year global investment veteran, Hamzaogullari believes the same long-term time horizon should be applied to both public and private equity, given their close correlation.

 “If investors are concerned about public markets being overheated and overpriced for whatever reasons, then they should have the same concerns about private equity since capital flowing to both public and private markets is chasing the same themes and opportunities,” he says, citing AI-related technology companies as an example.

“AI is probably the biggest structural change in technology that we’ve ever seen and, looking back at every major disruption in history, for example, railroads, electricity and the internet, our observation is that the extent of the transformation is consistently underestimated while the number of presumed winners is overestimated. That’s as true in private equity as it is in public equity.”

Perceptions of volatility and performance

Time horizons aren’t the only differentiating factor that can distort perceptions of performance.   

The method and frequency of valuing public and private companies is also vastly different, which can give the impression that public markets are more volatile.

There is a general belief that private equity can deliver public equity-like returns with materially lower volatility, but that value proposition is largely dependent on infrequent and subjective valuations.

According to Hamzaogullari, if private equity managers were mark-to-market like public equity managers, meaning they had to get an actual value for their assets, most of their valuations would be materially lower and their return profile more volatile.

He cites, as an example, the period from 2008 to 2009 when listed equities seemingly underperformed private equity.

“After the Global Financial Crisis, when the entire public market was depressed, private equity assets would have been depressed too if they came to the public market,” he says.

“A good portion of private equity goes public when they exit, so there’s a close correlation between public and private markets, which is why I find the argument that private equity is better than public equity so amusing.”

While Hamzaogullari acknowledges that public markets aren’t perfectly efficient and are impacted by behavioural factors, such as overconfidence, overreaction and herding, which can distort short-term valuations, he believes that over the long-term they are efficient.

“They may not be efficient every minute of every day but, over the long-term, assets are valued correctly,” he says.

“As an active manager, we exist because of inefficiency, and our job is to exploit inefficiencies but over the long term I believe markets are efficient.”