Private equity–a big propeller for economic growth

It is an alternative investment class, provides huge opportunities.

RIYADH: In developing countries like Pakistan where capital markets do not have much depth (liquidity), encouraging private equity investment plays an important part in ensuring that capital is available where it is required, and hence it is big propeller for economic growth.

Let’s start by asking why are most investors in financial assets only interested in stock and bond markets, to the extent that even the premier CFA institute examinations and most university programmes almost solely focus on these two.

Here is why. These are the only two saving vehicles (asset classes) that are large, liquid and have visible prices. World public equity market capitalisation at $50 trillion (Bloomberg) and bond market debt outstanding at $95 trillion (CityUK), provides decent saving depth for global GDP (annual income) of $65 trillion.

The tangible asset market, mostly real estate (but including under/over-ground commodities and personal property), is even larger at $150 trillion, but is illiquid, due to relatively large ticket deal sizes and non-standardisation and hence is called an ‘alternative asset class’.

Private equity or shares of unlisted companies are interesting. They are grouped as alternatives due to liquidity constraints and big deal sizes, but otherwise seem the same securities, ie equity.

Before I elaborate, let’s try to ascertain the total size of private equity market. According to Credit Suisse 2011 Global Wealth Report, total net wealth in the world is $231 trillion. From this, we minus the value of ‘real’ assets, stock markets and $5 trillion in cash and demand deposits. The size of bond market is not included in the calculation as one person’s bond asset is another’s liability and it cancels out. Hence, estimated value of private companies comes to $30 trillion, which is smaller than the public equity market but still huge.

In comparison, private equity funds worldwide currently manage less than $4 trillion, including funds available for investment, and so no one is kidding when they say that this is a class full of opportunities. Indeed, Warren Buffet is famous for his public equity investments such as Coke and Washington Post, but a large chunk of his returns came by using Berkshire’s insurance cash flows to buy distressed companies and turning them around. Hence, he has also been a great private equity investor.

For private equity funds, valuation is the easy part. The major leg work is the due diligence, getting the agency agreements in place and management oversight. Hence, this space taps into the entrepreneurial and administrative ability of those running the fund, forcing them into the field. Therefore, learning direct private equity investment, can only occur ‘on the job’, rather than at business schools.

So how is this extra running around compensated for. According to a research by Cambridge Associates, private equity funds have returned 13.1% annually in the US between 1987 and 2011 compared to 9.28% for the S&P 500 index. This is the difference of ending up with $1 million or $2.6 million.

These are net private equity returns to investors, meaning that fund operators also keep management fee and carried interest (performance fee) on top of return on their own investment, not to mention the insight and industry knowledge that is gained from hands-on approach. For the passive investor, his work is obviously to select the fund managers with the best track record.

Finally, appraised private equity assets are supposedly less volatile along with higher returns. This is probably more of a camouflage, because they are affected by the same macro and industry drivers as listed companies. It is just that their valuation takes place quarterly and are inherently more difficult to value as a public market for discovering prices does not exist. But hey, stop for a moment. Let’s turn the argument on its head! Maybe it is the public markets that distort value more by being more volatile than they should be?

According to Jeremy Grantham, a well-known fund manager at GMO, the stock market’s ‘long-term fair value vs GDP growth trend’ has been remarkably consistent, within +-1% for two-thirds of the time for the last 100-plus years. In contrast, two-thirds of the years, the ‘actual stock market returns vs GDP growth’ have been within a much wider band of +-19%.

Data is from the US, but it is obvious that stock markets everywhere, over or undershoot underlying fundamentals by a big margin, something Grantham attributes to career risk of financial professionals and other human behavioural factors.

Conclusion: Private equity presents a huge universe of opportunities and can certainly add value to High Net Worth (HNW) portfolios containing only stocks and bonds, by both increasing return and lowering true volatility at the same time. It is certainly an alternative investment class, but not only because of low liquidity, but rather because it marries management science with pure investment.

The writer works as an economist and portfolio manager

Published in The Express Tribune, October 1^st, 2012.