Australian Financial Review Opinion
11 June 2018
Property prices are in the headlines. Assuming they are for investment purposes, returns are near impossible to measure using an index. Each entity has a unique outcome allowing for differentiated transactional costs, rental income, maintenance, gearing level and holding period. Private equity investments are in the same boat.
That does not, however, stop many claims about the relative outcome of both these assets – invariably with the data purporting that they outperform listed equities.
Large industry super funds have gravitated towards unlisted assets in recent years. It makes sense, as they can reasonably assume the capital within the portfolio is likely to move out very slowly and predictably, allowing the fund to manage the illiquidity of such investments. The other important outcome is a degree of stability given these assets are not marked to market like equities.
The key parameters to value unlisted assets are based on discount rates in the case of property and infrastructure. A range of methodologies includes comparable entities, secondary transactions and cash flows, each of which may be different between the private equity firms.
Accessing such assets as an individual investor is far from easy, though there are local venture capital and private equity options that occasionally raise capital from sophisticated investors.
Global is even harder. Private equity managers that have a good track record can readily draw large-scale money from institutional investors and have minimums in the millions of dollars. For others, a fund-of-fund vehicle is the practical option, recognising that it likely dilutes the best of the bunch and has a loaded fee structure.
The question that does arise is whether a company is a better investment within a private equity framework versus as a listed entity.
Patience pays off
The commonly-cited benefits of private capital are that it can afford to be patient and that the required reporting on results, board structure remuneration and other structural elements that frame a listed market are much lower. The management team can be directly influenced by the investors and the capital management set to optimise the return rather than adhere to shareholder attitudes. The primary function of private equity is arguably to ready the company for another investor cohort.
It should not be surprising that private equity can outperform a listed equivalent. The companies within private equity are often at an early high-growth stage, are being restructured or consolidating within an industry. But the factual evidence on the level of returns is messy, with private equity research firms creating their own indices to unsurprisingly support their case. Investors who can access them should regard them as within the equity allocation, albeit the correlation appear to be modest due to the timing difference and valuation measures.
For most, there are investment criteria that can be transferred from private equity to listed markets.
The most obvious is patience. Corporate strategies take time to unfold, yet with the focus on short-term reporting management often adapts to shareholder demand.
Ascertaining the attitude of the company to stick with a program if the path toward an outcome is realistic matters more than knee-jerk reactions to the latest signal from the shareholders. Appropriate incentives benchmarked on the financial returns rather than stock price are another feature.
Listed companies that emulate the character of private equity while taking on board the accountability of public scrutiny are one of the sweet spots in investment markets.
Fund managers can be considered in a similar light. Some react to recent performance and chase their tail fearful of the criticism that they have not stayed in touch with the index. A number stick their head in the sand, refusing to acknowledge a different dynamic. Others consider if there is new evidence that should change their view and adapt accordingly.
This year the shifting pattern of sector performance across equities has been hard to match in the short term. Realising an investment just on recent performance is often cited as one of the "don't do" lessons in markets. Private equity does not, why would one in liquid markets?