# Private Equity's Other Illiquidity Premium

### Introduction

High total returns. Diversifying. Relatively low risk. Infrequent drawdowns that are eminently tolerable when they do occur.

These are all characteristics that an investor may think of if asked to describe the perfect asset class. Low fees would likely be on the list too, but of course these attractive characteristics must come at a cost, leaving investors to consider how much of a premium they are willing to pay for this asset class versus others.

Source: CEPRES Market Intelligence and Bain analysis; 2021 data as of 14 December 2021. Revenue shows median CAGR by year of exit. EBITDA margin shows estimated median CAGR by year of exit. Includes fully realised global buyout deals with more than $50 million in invested capital; excludes real estate and infrastructure deals. For the many LPs that are wary of the current deal-making environment for PE, liquid PE could offer an alternative way to gain exposure to PE’s stated return drivers without getting locked into richly valued companies with increasingly more expensive debt and likely headwinds to multiple expansion, and thus diminished return expectations in the coming years versus the returns that have been realised historically. Those past performance numbers may have historically made it tolerable for LPs to look past the drawbacks to PE noted in this paper and pay meaningfully higher fees, but we believe the outlook is decidedly murkier for PE at this time. ### Those Pesky PE Fees True alpha that is difficult to replicate, which some top-tier PE managers appear to be able to provide consistently, should command a premium fee, but in our view much of the PE industry is awash in ‘alpha’ that is generated via effortless multiple expansion; utilisation of, ahem, ‘accounting loopholes’31; and other somewhat inorganic sources of return amplification like leverage that we believe should not command much of a fee premium at all. And one certainly should not pay dearly for simple beta and/or replicable alpha that can easily be found elsewhere for a much cheaper price. Liquid PE may be worth considering as a significantly cheaper way to access many of the return drivers of top-tier PE managers. Active managers in most other asset classes with clear, undeniable beta exposure are heavily scrutinised as investors seek to separate alpha and beta and endeavour to pay only for true alpha to the extent that is possible. Disentangling the two does not seem to be as popular in PE. We believe every PE manager should be put under the microscope to assess whether they are bringing about significant operational improvements or other business enhancements in order to justify their fees. In our opinion, financial engineering alone is not a good reason to continue paying PE’s stubbornly high fees. As weaker PE managers are exposed, liquid PE may be worth considering as a significantly cheaper way to access many of the return drivers of top-tier PE managers, perhaps even with less true risk. This paper seeks to dispel some of the common perceptions that have driven PE’s pricing power, namely the belief that it is a diversifying asset class with low drawdown risk that offers high returns with relatively low total risk. Holes can be poked in each one of PE’s perceived benefits, but ultimately a large part of the reason for PE’s continued pricing power can be traced back to one of Porter’s Five Forces – there historically hadn’t been a sufficiently compelling substitute for PE, and many investors are still unaware that there is a more cost-efficient substitute now. If adopted more widely, liquid PE strategies that target the more nuanced beta or smart beta that traditional PE provides may even be able to give LPs more leverage in negotiating fees with traditional PE managers. We do not need to look too far back in history for an appropriate analogy. Just a couple of decades ago, passive public equity market beta became easily accessible and a viable substitute for actively managed public equity portfolios, and began chipping away at the fees charged by active managers. As a result, many managers disappeared or saw their pricing power erode significantly. Many that could demonstrate their ability to add real value versus the passive alternative survived, however, and in a number of cases have thrived. We believe we may be nearing that point with traditional PE. Surely there will be some PE managers that can demonstrate their added value beyond just levered beta exposure and continue to command attractive fees, but we have a hunch that many traditional PE managers would be unable to justify their current fees when their ‘alpha’ is truly scrutinised versus a more tailored benchmark. A thinning of the PE herd could be a good thing for the survivors as they face less competition for attractive deal targets and in theory could close deals at more favourable purchase price multiples, which in turn could generate better performance for LPs. But the big win for LPs could be gaining some leverage in their fee negotiations and performance-fee payments to PE managers. ### The Role Liquid PE Can Play in an Investor’s Portfolio If one believes that liquid PE strategies may be used as a fee-reducing tool or have potential as a way to ramp up PE allocations quickly, make tactical calls on vintage risk in traditional PE portfolios, and/or have a strategic place in an investor’s asset allocation, then it could be prudent to consider how this emerging option fits within one’s investment portfolio. We believe there is simply too much shared beta between public and private equity to reasonably expect PE to be a true diversifier. The simple correlation between PE and public equity – the 76% cited earlier – would seem to indicate that PE could indeed be grouped with public equity in a holistic equity allocation. The case for instead including PE in an Alternatives allocation is a bit weaker if a primary goal of one’s Alternatives bucket is to diversify versus the traditional public equity cornerstone of many asset-allocation plans. As detailed in this paper, we believe there is simply too much shared beta between public and private equity to reasonably expect PE to be a true diversifier. This is not a revolutionary thought by any means, as a number of institutional investors already combine PE and public equities in one allocation. Seth Kelly, the former CIO of US state public pension plans in both Pennsylvania and Missouri, stated that “we talk about public equity and we talk about private equity, and the only difference is public and private…They’re both equity, so when you’re thinking about it in a larger risk context, you’re thinking about equity.”32 At existing PE fee levels, however, this would result in an absolutely massive mismatch in the typical fees paid between investments within the same equity allocation. If one is simply looking to access many of PE’s key return drivers – and the outperformance of passive public equity markets that are expected to result – then liquid PE may be a more cost-efficient alternative. After all, it is difficult to justify paying substantially more for a highly correlated portfolio that may very well be riskier than the other portfolios with which it is correlated. Turning our attention to the excess return correlation between traditional PE and liquid PE in order to strip out the impact of the shared beta that drives up their total return correlation, it would appear at first glance that PE and our liquid PE portfolio actually are diversifying to each other with a 14.9% correlation,33 and thus could be held together as complementary investments within the same asset class. At the same time, this might invite the question of whether liquid PE is achieving its goal of mimicking PE’s key return drivers. If we strip out the impacts of PE’s smoothing and the substantial leverage it enabled, it becomes a lot more difficult to make an argument for why PE’s fees should be many multiples higher than that of liquid PE alternatives. This analysis becomes quite interesting when we go one step further and examine the same excess return correlation but instead use the aforementioned smoothed returns of the liquid PE portfolio, which shows that the correlation between PE and liquid PE jumps to a rather high 87%.34 In our view, this analysis indicates that the key alpha drivers are actually quite similar between the two and it is really just PE’s smoothing that is creating the illusion of possible alpha diversification. Once smoothing is removed from the equation, there is much less difference between PE and liquid PE. Hopefully this has already become intuitive over the course of this paper, but we still find the magnitude of these empirics a bit startling. Regardless of how investors approach their PE and public equity allocations, we firmly believe that liquid PE strategies can be valuable in multiple ways and for certain investors it may be in their best interest to at least consider them. Several potential use cases for liquid PE include: 1. Cash management tool. Most institutional investors seek to minimise cash drag in their public equity portfolios. Many investors also pursue this public equity best practice in PE by investing committed capital that has not yet been called, but based on our conversations this is often done in fairly blunt fashion rather than investing committed PE capital in nuanced strategies designed to match the return drivers and key risk exposures of one’s PE portfolio. In addition, liquid PE can be a way to ramp up an increased PE allocation more quickly. 2. Cost-efficient core in a core-satellite approach to PE. In this approach, liquid PE’s diversified exposure to popular PE industries and return drivers allows for satellites to be (i) high-conviction buyout funds that use expertise in a specific industry or other niche of the market to drive higher returns, and/or (ii) higher growth segments of broader private equity, like venture capital, that may be significantly narrower in their industry exposures. Investors that pursue direct investments and/or co-investment opportunities may also benefit from having a more diversified exposure at the core of their allocation that then allows them to absorb any potential concentration risk stemming from a smaller number of direct or co-investments. 3. More nuanced PE benchmark. Liquid PE may be able to help LPs reduce the total fees paid to PE by identifying replicable sources of PE alpha and generating expected outperformance of standard public equity benchmarks, thus providing a more tailored benchmark on which to base performance-fee payments to PE. Regardless of one’s views of liquid PE, if we strip out the impacts of PE’s smoothing and the substantial leverage enabled by that smoothing, it becomes a lot more difficult to make an argument for why PE’s fees should be many multiples higher than that of liquid PE alternatives, or public equity strategies more broadly for that matter. Simply marking companies’ valuations less frequently and reporting performance with a significant lag may be seen as a benefit by some Limited Partners (‘LPs’), but in our view it should surely not command a huge fee premium. If smoothing of returns is a, or the, leading benefit of PE – which it may very well be – then perhaps application of smoothing techniques could be explored in other asset classes or at least for liquid PE strategies that sit within a dedicated allocation to traditional PE.35 That is a topic for another discussion, but at the very least we believe that the perceived benefits of PE should be scrutinised more closely by investors and alternatives like liquid PE should be considered as a suitable alternative or a complement to a broader PE allocation. 1. Source: Data pack that accompanies PitchBook’s 3Q 2022 “US PE Breakdown” found at www.pitchbook.com/news/reports/q3-2022-us-pe-breakdown. Total PE capital raised in calendar years 2017-2021. Note that 2021 set a new calendar year record with$366.1 billion raised, and the $258.8 billion raised in the first three quarters of 2022 had the year on a pace not far off 2021’s record high. Buyouts have been easily the largest recipient. 2. While we use the term “private equity” somewhat loosely, this paper is focused on buyouts as representative of PE, not venture capital, growth equity, or other PE strategies that can play a different – and potentially important – role within the corporate value creation chain and may produce more idiosyncratic returns for investors. 3. Sources: Cambridge Associates, now via IHS Markit, and FTSE Russell for Russell 2500 Index. Simple return correlation using quarterly returns for indices noted from first quarter of 1997 (the first quarter currently available for the Cambridge Associates index) through the first quarter of 2022. 4. For example, “Should Defined Contribution Plans Include Private Equity Investments?”, Financial Analysts Journal, 18 July 2022. 5. https://www.mckinsey.com/capabilities/ strategy-and-corporate-finance/our-insights/reports-of-corporates-demise-have-been-greatly-exaggerated 6. Other than 2016, which was heavily influenced by the outlier$67 billion Dell-EMC deal. Source: Pitchbook Q3 2022 US PE Breakdown: www.pitchbook.com/news/reports/q3-2022-us-pe-breakdown. We acknowledge that the public-markets selloff in 2022 presented many opportunities for take-private deals, but 2021 was quite different in that regard.
7. Year-over-year increases in nine of the past 10 years, with the one exception being 2021, which with the benefit of hindsight was perhaps an inauspicious time to be drawing down capital and closing a flurry of deals ahead of a massive market slowdown and widespread downward resetting of valuations.
8. This correlation actually surpassed 90% as recently as mid-2020 on a rolling, trailing four-year basis, using four years to approximately match the latest median holding period of buyout companies.
9. https://www.institutionalinvestor.com/article/ b1kfbtq1j02js3/How-Private-Equity-Became-a-Beta-Play
10. At Man Group, we seek to do this very explicitly in some of our strategies focused on downside mitigation.
11. We recognise that many investors turn to liquid assets first when they need to withdraw capital and these assets need to have updated valuations at that time, much like the situation with the UK gilts market in September-October 2022. This example happened during a period of market stress, but unfortunately there is no option to avoid marking portfolios of public securities simply because one expects the assets to rebound eventually. PE, however, can do exactly that.
12. Source: Man Numeric. Analysis uses full quarterly returns of live versus simulated smoothed portfolio from 1 July 2018 through 30 September 2022.
13. Source: Man Numeric, December 2022. The average size of companies in buyout funds just passed $1 billion USD during 2021. For comparison, the small-cap Russell 2000 Index has a median market capitalisation of$1.03 billion USD as of 31 October 2022.
14. We acknowledge that there are other payoffs shown in Figure 2 that are favourable to PE, notably more profitable companies being in favour as well as lower risk, more predictable, less cyclical companies.
15. There are various ways to measure this, but the Financial Times notes a debt/EBITDA ratio of PE deals that is approximately double that of equivalent public companies in its September 2021 article “Private Equity is Leveraged Equity” (www.ft.com/content/375306e7-0d64-4bea-a75f-e8a500facf1d).
16. Using both 1) sector-neutral Barra model spreads and 2) allowing for sector-driven influences.
17. Source: Empirical Research Partners, Debtors’ Prison Part III: Rising Rates and the Debt Burden of Corporate America, 27 April 2022. As noted by Empirical Research Partners, only about 15% of outstanding debt for large companies is rate sensitive, but for a fairer comparison with PE the focus should be on small companies. Approximately 30% of public small-caps’ outstanding debt is rate sensitive, a figure that is dwarfed by the 70% of debt tied to PE-linked firms that is rate-sensitive.
18. One glaring example (albeit less headline-grabbing than the sudden collapse of the cryptocurrency exchange FTX in October 2022, for example) of a misleading lack of markdowns is Southland Royalty, at one point a PE-owned energy company, which went bankrupt only 83 working days after being marked by its PE owner, EnCap, at 99% of its invested equity. As noted in the Financial Times article “Private Equity and the Mark-to-Market Myth” (www.ft.com/content/ a09f0885-f15a-4ad3-b4ae-3bc9f2bc5430).
19. Source: Cambridge Associates, December 2022. Note that this first-quarter 2020 return steadily declined again in subsequent reports.
20. Source: Bain & Company, Global Private Equity Report 2022 (https://www.bain.com/insights/topics/global-private-equity-report/).
21. We ran this analysis using 2014 as the latest vintage year in order to give PE portfolios sufficient time to mature. Only time will tell what more recent vintages ultimately yield for investors, but it is generally true that more recent vintages have more exposure to investments made at higher purchase price multiples and that their reported portfolio values have larger percentages that are in unrealised gains.
22. Source: Man Numeric. Analysis uses full quarterly returns of live versus simulated smoothed portfolio from 1 July 2018 through 30 September 2022.
23. As posited in “Catering and Return Manipulation in Private Equity,” 18 October 2022 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4244467), which was reported on by Hannah Zhang of Institutional Investor, who cited the report’s authors’ view that “Some PE fund managers manipulate interim returns in a manner consistent with their investors’ desires.” Source: Institutional Investor, “How Allocators are Complicit in the Manipulation of PE Returns,” 27 October 2022 (https://www.institutionalinvestor.com/article/ b20dnrl3lcx078/How-Allocators-Are-Complicit-in-the-Manipulation-of-PE-Returns).
24. Such as subscription lines and other methods of amplifying PE’s returns somewhat artificially.
25. Source: A. Coupe, “Assessing Risk of Private Equity: What’s the Proxy?,” CAIA Member Contribution, Q3 2016. Also, keep in mind the significant negative payoff to the higher beta factor during down markets, as shown in Figure 2.
26. Source: GPIF, “Alternative Asset Replication Using Exchange-Traded Assets”, March 2021 (www.gpif.go.jp/en/investment/Alt_rep_report_en.pdf)
27. Source: “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting” by Erik Stafford, Harvard Business School, 2015 (https://www.hbs.edu/ris/ Publication%20Files/ReplicatingPE_201512_3859877f-bd53-4d3e-99aa-6daec2a3a2d3.pdf)
28. Acknowledging that there are investors who believe the impact of interest rates on the valuation of high-growth companies is overstated.
29. Source: Bain & Company, Global Private Equity Report 2022.
30. Source: Bain & Company, Global Private Equity Report 2022.
31. Such as subscription lines (which are not discussed in this paper) and healthy interest deductions, to name two examples besides smoothing.