This chart prepared by KKR is a great encapsulation of where institutional investors’ focus is.  It shows expected allocations, grouped by asset class, compiled during the 2nd half of 2017.  What we find astonishing is the glowing admiration of Private Equity at the 10th year of an economic expansion.  This punctuates the “golden age” of private equity:

It’s not surprising why Private Equity is so en vogue.  It has been billed as a panacea to the institutional investor’s ills: returns in a world seemingly bereft of them.  This reality is even more stark in the pension community, faced with growing obligations to their constituents.  Many public plans have been dealt an undeniably tough hand in terms of funding ratios.  This is no fault of the investment program which manage their assets, but it ultimately leads to a begrudging move further out the risk curve.

As discussed in a prior post, the benefactors in this cycle have been seemingly bar-belled: zero fee beta providers and higher fee providers of excess return or uncorrelated alpha:

Private equity has understandably been a large benefactor of this move, given the robust returns they have posted versus, lower beta asset classes such as hedge funds.  Further, there is a growing belief that capital allocators have more edge in nonmarketables versus other alternatives, given that profitable placement can lead to follow-ons.  Marketables continue to get farmed in-house or to zero cost providers such as Vanguard/Blackrock.

Why have PE returns been so good?  Well, it depends on your perspective.  The optimists believe that Private Equity is an optimal form of equity investing.  Underperforming companies should benefit from the trifecta of improved operational and sales practices, the luxury of avoiding the ripcurl of quarterly earnings, all while unlocking equity returns by optimizing the capital structure.

Pessimists will point out what you’re buying is leveraged public market beta.  I would posit the truth lies in between, where the synthetic exposure is a form of levered beta, but the risk of owning such an asset is best stewarded by operational experts who understand how to manage it.

Let’s not forget the implicit benefit of inaction caused by an inability to act.  This chart by BlackRock is a staggering reminder:

In a regime where being blindly long beta has been your best friend, some of the structural characteristics of private equity undoubtedly have helped.  Infrequent marks and a structural long-term perspective help keep investor returns closer to time-weighted returns.  In short, it keep its LPs from being their worst enemies.

All things seem to be pointing up for PE, but investing is often about counter-cyclicality rather than trend, and there are three troubling issues with private equity as a driver of sustainable alpha moving forward:

  1. Huge capital flows will invariably lead to heightened competition. Heightened competition in turn can lead to managers reaching on valuation and risk, ultimately diminishing long-term alpha.
  2. A rising rate environment putting an end to historically loose credit standards. The days of cov-lite turns may come to an end.
  3. Private equity’s time horizon is much longer than marketables, but not perpetual.  Series need to be crystalized every 7-10 years, and so exits must be made.  This may lead to a deluge of sellers and a market saturated with unwilling buyers.

Point #1 is axiomatic of the capital cycle and applies across all investing: flows invite alpha compression.  Investors are often served best by allocating counter-cyclically if they’re able to stomach short-term underperformance.  Point #2 is more macroeconomic prognostication and is not a given truth by any means.  But any watcher of the Fed has to be worried about credit risk in such an environment.  Just because a company is private does not mean its immune to the business cycle.  Leverage works both ways.  Point #3 remains to be seen, especially with PE’s little cousin VC.

All of this leads me to a quote by Bertrand de Jouvenel, in talking about the problem of politics.  As he said several decades ago:

“The assumption that political problems are of the same kind as those set to us in the classroom, or as those which exercise the minds of geometricians, is optimistic in so far as it carries the implication that there is a right answer to every problem.” 

It’s easy to think that the problem of underfunded liabilities is to reach to the one thing that has reliably worked, but if it were so easy, investing would be left to the geometricians.

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