Providers have been storming into the rapid growth of private equity as an asset class, reflected in the national and international growth of feeder funds and fund of funds. However, these product groups are associated with high pricing and common misalignments, according to Koen van Mierlo and Emile van Thiel of Bluemetric in a recent said in a recent interview with Investment Officer NL.
Bluemetric advises about twenty families, mostly supported by a single or multi-family office, who collectively have over 4 billion euros of invested assets about their asset allocation to private and public markets.
“While the democratisation of the asset class is a good starting point, investors should look more towards a rationalisation of private equity,” said Van Thiel, who founded Bluemetric in 2015. The assumption that private equity achieves higher returns than public equity is a market failure, he argued. “The dispersion in manager returns is high, compared to other asset classes.”
«If you discount the return for the average leverage that private equity applies, that advantage over shares disappears,” he said. “In addition, private equity funds often invest primarily in small caps and value companies, and more recently in growth companies, so that a comparison with the broad equity market is not appropriate.”
Just this year, private equity providers are praising their own products, claiming that they (will) suffer less than shares and bonds. Private equity is said to be less sensitive to market sentiment anyway.
Imperfect correlation
Van Mierlo spoke of an ‹imperfect correlation› of private equity with other categories. “For the first time in twenty years, bonds and equities are falling together,” said the head of Bluemetric’s analyst team. “Usually equities and bonds react opposite to growth announcements, but both react negatively to inflation. This year, you read more inflation reports than growth reports,” he explained. “But does private equity offer protection? I wouldn’t say there is a negative correlation, because this market is still subject to equity risk.”
He agreed that the decline in private equity is less deep, but warns against return smoothing, whereby providers literally smooth their returns over the long term, so that the return development looks as smooth as possible. After all, private equity providers may base themselves on their own valuation standards, as a result of which the interim determination of returns is not always equally representative.
“On paper you may not see such a strong correlation,” said Van Mierlo. “But that does not mean that the risk is not there. And it is precisely the delayed valuation of private equity that we are very critical of. In order to compensate for the movements of the public markets in the private market portfolio, we always advise clients: look at the net asset value on a certain date and take a cut in that value, and then see what that does to the internal rate of return (often used by providers, ed.). This allows you to look more realistically at the performance of your portfolio.”
Despite this, he and Van Thiel “definitely” speak of a diversification benefit of private equity alongside other investments. “If only because you have access to a part of the market that not everyone has access to.”
Flaws in the offering
Van Thiel did warn against the flaws in the product offering, such as the concentration risk, caused by a strong home bias of private equity funds and a preference for venture capital funds. The refinitiv venture capital index, for example, is down about 50 percent this year.
Other flaws he mentioned are an excessive focus on track record, but also: “talking about an ideal exposure. That is not enough. Take an exposure of 20 per cent. What is this 20 per cent then? Is it committed, is it invested, do you look at the NFIP? You want your exposure to be as optimal as possible. If you reserve 35 percent for capital calls and only invest the remaining 65 percent in private equity, you are just as well off with a stock market return. You want to have put 100 per cent to work.”
“At the same time, warnings about a lack of liquidity are always heard in the area of private equity. That is precisely the reason why the category is not available to small investors and why banks only offer it sparsely.” Van Thiel stated that there are solutions to this, such as lending a client portfolio or offering it on the secondary market, although he would only recommend this in a stress scenario.
“Cash flow forecasting is also important here,” said Van Mierlo. “So modelling the pace at which the - for example - twenty funds to which you want to allocate assets over the next five years will be withdrawing and distributing money.”
This is quite a data exercise, he warned, with the divergence in j-curves of different styles and funds.” Venture capital, for example, has a long, deep j-curve, with any big hits only occurring after about eight years. With buyouts and secondaries, the curve is less deep because the first distributions can follow quickly. In the end, we try to have the parameters arrive at the exposure desired by the client. So a client knows what the cash flows can be, with a small margin of error.”
Under the bonnet
Van Thiel and Van Mierlo said they believe that investors should look under the bonnet more often in private equity funds. Suppose that a fund has invested in fifteen deals, but the return is mainly the result of one big hit, then it carries a great risk. Without that hit, it would probably have underperformed.
‹We miss the exposure to returns and risks from multiple dimensions,” said Van Thiel. “The IRR is often used as a measure of expected return, but it loses relevance when a fund achieves a high distribution early in the cycle. It is better to combine it with the multiple and then also look at the extent to which the fund’s return is determined by outliers - both positive and negative.”
«And to the direct alpha, that is, how private equity performs compared to the public markets», offered Mierlo. “The chosen benchmark is important in this respect: the risk profile must be comparable in order to correct for the risk exposure. Only then do you have the total picture: is your private portfolio adding value compared to your public portfolio.”
Back to feeders and fund of funds, why are they suboptimal? According to Van Mierlo: «If you historically achieve a return of 3 to 5 percent with private equity compared to the public stock market and you still have to pay 1 percent on that feeder layer, then that is sub-optimal.”
“And meanwhile, you’re driving the rear view mirror because this outperformance is based on historical funds. There used to be a lot more divergence between valuations in the public and private markets, with private being a lot cheaper. That discount is now smaller, as a lot of money has flowed into private. That puts pressure on future returns.”
Bluemetric has been in existence since 2015 and was set up by former UBS members van Thiel and Paul Haal. The firm’s 13-strong team analyses scenarios and risks and makes recommendations to clients based on these, which clients can then implement themselves.
Bluemetric’s clients invest in around 120 private equity funds from some 80 providers. “We have advised a substantial part of them”, said Mierlo and Van Thiel.” Some clients have built their portfolio themselves or with another adviser. We then try to create diversification and stability in a portfolio.”