PlayBook 4Q 2018
How you could invest in every single private fund strategyDecember 14, 2018 View comments (2)
Should you have been able to invest in Uber? What about a lower-middle-market buyout fund? What about getting exposure to the burgeoning universe of alternative investments in general with the same ease of buying into an S&P 500 index?
A few hundred dollars invested in Uber's seed funding would now be worth millions. Such a ludicrous return being off-limits to all but those deemed eligible for such funding seems quite unfair. On the other hand, how many investors would have lost that money completely by backing early competitors to Uber that have since flamed out?
There are significant pros and cons to being able to invest in private markets. But especially as they become more institutionalized while the public market universe consolidates, I contend that retail investors should be able to gain exposure to the full gamut of alternative investments.
What would that look like? This piece explores precisely that. First, a little background:
Balancing risk and rewardThe question of whether a typical investor—accredited or no—should be allowed to buy any type of security has been contentious for decades. In the wake of the 1929 market crash, the US Securities and Exchange Commission's decision in 1933 to allow only accredited investors to purchase shares of private companies made plenty of sense. After all, not every person with money to buy stock in a private company, or a piece of a pool of securities, is sophisticated enough to understand the risks or even actual returns inherent in ownership of any stock. Protecting people from their own overly impulsive decisions was the paramount concern. The Investment Company Act of 1940 fleshed out this essential belief, requiring disclosure of material details about each investment company and restricting short-selling by mutual funds. (Hence the eventual construction of liquid alternatives that could comply with these restrictions yet offer at least some exposure to alternative assets to ordinary investors.)
On that foundation, far more complicated systems of reporting for companies that wished to float stock on public exchanges were gradually erected. In fact, they've grown to such a daunting height that although one can find out quite a lot about the most detailed minutiae of Amazon's business, such levels of oversight often discourage all but the largest private companies from going public.
But clearly there is a conundrum of sorts here. On the one hand, retail investors can access public markets via ETFs or mutual funds, and benefit from passive index products flourishing, but they can't access the true outliers of growth within private markets. This asymmetry is due primarily to opportunities for significant gain being increasingly concentrated in private markets, as the exclusive information that alpha is derived from continues to dissipate within public markets. But, asymmetry of information comes with a consequential price: Anyone or any firm willing to back private companies at the early stage must accept higher risk and surrender their money for potentially a very long time. It could be argued that certain arenas of private markets, say, Blackstone's flagship fund, are approaching levels of risk comparable to safer public equities. But other risks still exist for much of the PE fund universe—e.g. leverage and agency.
Is there a happy medium?The entire industries of VC and PE thrive on the gap in efficiency and information flow between public and private markets, as such sophisticated investment firms exist to enable private companies' growth while exacting a hefty fee in exchange for such risk. But as few, if any, retail investors can still get exposure to such businesses, even PE and VC's success and growing institutionalization doesn't really assuage matters of access.
Title III of the JOBS Act, the crowdfunding legislation that finally lifted some of the curb on retail investors backing startups, hasn't led to any significant changes. Granted, it did lead to some tentative openings to private investment opportunities, such as alternative lending options that enable retail investors to pledge small amounts, say as small as $10. Whether that has been due to consumers' reluctance to back unproven startups, or the legislation didn't address regulatory burden to a sufficient degree, still is unproven. In other venues, entrepreneurs have sought to establish trading exchanges for fast-growing unicorns in the US, for example Lagniappe Labs, which has created an index on which 100+ unicorns are listed. What is clear is that, thus far, there isn't much you can do to gain broad exposure to not only fast-growing private companies but also other private companies that are more mature and, consequently, less risky.
This argument resembles an initiative some industry professionals and pundits have suggested—namely, national retirement savings plans that should be able to access alternative assets and could be a potential solution to the looming pension crisis in the US (and elsewhere). The counterpoints are not insignificant: unacceptable levels of risk and complexity, moral hazard, and the fact public markets by now offer enough venues for anyone to invest to match their needs, plus they're starting to close the gap on private funds' higher performance.
Private markets still offer outperformanceThere's growing evidence that the gap between PE returns and public market equivalents is shrinking. VC has always been, by and large, a sucker's game for all but the top decile of funds. Similarly, risky, publicly available value stocks are now gaining in popularity, and rightfully so.
The unprecedented bull run in public equities observed since the depths of the financial crisis was an outlier largely due to one major factor, the elephant in the room—a never-before-seen experiment in quantitative easing and subsequent inflation of all financial assets. There's a reason that in every bout of market volatility that has occurred during that run, experienced investors proclaim to the rooftops that the dip must finally be nigh. Everyone has been waiting for the other shoe to drop for years.
Shoes do eventually tend to drop after being held long enough. And although the long lockdown periods of private funds are one of their biggest drawbacks, they can also be the source of attractively risk-adjusted returns, unaffected by quarterly drawdowns or broader market volatility to a large degree. Fund managers have greater ability to plan for optimal liquidation and manage portfolios away from the harsh spotlights of quarterly earnings. As for the promise of small, public, value stocks, they can play a useful role in private portfolios, as well—more on that later.
A brief caveat must be noted: Currently, private investment arenas are crowded and overly competitive, largely due to institutional investors flooding the environment with capital in search of higher returns, plus the entrance of nontraditional investors*. Thus, returns are likely to compress overall and PitchBook data already indicates that the level of outperformance for even top PE funds is in decline; the top-decile PME level for PE funds topped 2x in the late 1990s and early 2000s and has since averaged 1.34x for 2006-2015 vintages, not surpassing 1.5x since 2005. Yet this market condition will in turn change, as the number of active fund managers in PE, for one, is decreasing slowly but surely. Venture and private debt are likely to follow thereafter—the latter not so much due to culling of managers via competition, per se, but rather due to market reversals impacting incautious managers more than anticipated.
In short, both markets will evolve and revert to longer-run trendlines, as cycles tend to do in the long run. And in that long run, private investment strategies are likely to outperform even if many classic strategies become more institutionalized, due to information asymmetry. The return spread will just be narrower than in the past.
But a narrower return spread does bring up a critical point. For best results, retail investors will need access to not just PE, or VC, but rather as wide a spectrum of private investment strategies as possible, especially across company lifecycles. The reason is simple: mitigating risk across private strategies' varying levels. Buyout funds do not have the same risk characteristics as VC, as VC doesn't have similar risks to mezzanine debt, for example. There are overlaps, to be sure, but a lack of correlation and the potential for hedging provide sufficient justification for portfolio construction.
A pool for all private marketsSo how, precisely, would investors access private market strategies? What is required is something akin to a fund-of-funds, wherein a single administrator operates a vast pool of securities in perpetuity spanning the entirety of the private market, with the securities corresponding to shares within respective funds as well as potentially private company shares— e.g. a model similar to private exchanges operated by Nasdaq or SharesPost. Complex-but-not-incalculable valuation models would have to be used to accurately value these securitizations of buyout, venture, debt and other types of assets. Potential duration, liquidity and forecast value will all play into said models. The composition of the portfolio will have to be at a sufficient scale to allow liquidity and volume, plus diversity of strategies required. Target dates could serve as a useful organizing principle. Should funds fall short of performance for a prespecified period, then customary clawbacks would kick in to avoid performance drag and incur replacement, just on a potentially shorter timeline that would be modified accordingly to be fair to both fund manager and the pool operator. Here's where a balance of small, publicly traded value stocks could serve as a diversifier and tracking portion for a typical portfolio mix. Retail investors would have the option to select their levels of risk, amounts, etc., much like in normal investment platforms nowadays.
At a basic level, the process would look something like this. A seed-stage venture fund manager would have the option of receiving capital from this pool, in exchange for pledging a portion of fund shares, with typical terms except one: the return of capital after a prespecified period, potentially earlier than the fund's lifecycle, should it operate at a loss long enough. Reporting would only be as onerous as typical LPs require. The overlying pool of securities could be thought of acting as a sidecar LP to hundreds of private funds, providing a pocket of capital for the entire fund duration plus any prespecified period.
Why should fund managers buy into this pool of capital? Any pocket of sidecar capital that has as long of planned duration as this pool of securities would have that you can get on typical terms is advantageous. It's already clear why ordinary investors should buy into this pool, even if it would be riskier on a liquidity-adjusted basis than the S&P 500.
The key challenges and consequent reasons such a vehicle doesn't exist are scale, level of risk, liquidity and moral hazard. (Frankly, liquidity may be the predominant challenge, which is why a large base of capital is required and one of the bigger difficulties in this plan.) To match the full spectrum of risk and return in private markets, the scale would have to span the innumerable strategies from angel syndicates to mega-buyout funds. The level of risk, given leverage and lock-up periods, would dwarf mere equities, as investors could easily see their portions wiped out unless some money was guaranteed (and passing on clawed-back capital at that scale would dissuade fund managers from buying in). Liquidity only works if cash collateral at sufficient size exists to redeem up to a guaranteed level. And moral hazard is definite because the final key point of this pool of capital would be its lack of disclosure. Private investors jealously guard proprietary deal flow and portfolio company information. To persuade them to enter a common pool, the constituent corresponding securities would have to be blind and representative; only the pool administrator would know the actual components of the pool. As mentioned previously, information is alpha, and it's why private markets are more secure in the long run in potential outperformance than public equities.
These seem to present insurmountable obstacles, but I'm not so sure. In closing, here's my multipronged proposition to each of those challenges.
A sovereign solutionA key consideration is the amount of collateral necessary to not only meet a certain hurdle of redemptions to retail investors but also to act as a sidecar LP to potentially thousands of private funds. Few institutions command balance sheets that can handle such levels of capital. But certain firms that are well-suited to handling gargantuan sums while fixated solely on the long term already exist: sovereign wealth funds. One major twist to the traditional SWF model would be required, that of overseeing others' capital. Yet that isn't too untoward. Recruiting talented managers in a fashion similar to Norway's Global Pension Fund is one potential avenue forward.
Whether through privatization, natural resources allocation or the like, a sovereign wealth reserve fund could command a large pool of capital that could guarantee retail investors at least their money back, plus an initial, even larger pool of capital that could act as the sidecar LP across thousands of fund manager relationships. This could negate much of the risk, if not all, while portfolio risk could be diversified away somewhat already.
As much as we like to think we are rational and sober-minded, at a certain point, we outsource much of our thinking and trust to hopefully reliable investment brands.
Next comes scale. How to build relationships with thousands of fund managers of all strategies? One method could be SEC guidance that private funds can raise, on generous terms, at least a percentage of capital from this reserve fund that is proportional to their overall fund size. Scale would then be solved from the fund managers' perspective, while from the reserve fund's perspective, as each commitment per specific fund grows proportionately per size and type, the challenge becomes mustering sufficient funds to meet what's required. Presuming at least 10% of current dry powder in private investment strategies would be necessary to construct a sufficiently diversified, wholly private markets portfolio, approximately $180 billion is the prospective size of this fund. It's a big number— if each member of the adult middle class in the US invested $1,500 in the fund via an exchange operated by this sovereign wealth fund, you'd hit that mark. Ambitious, to say the least, but is that impossible?
The last argument is perhaps my most cynical. If you could get even a small percentage of your money back, and could invest as much as you like, with the only caveat being that this percentage of your money will be locked up but could outperform public equities by a decent margin, would you do it? Bear in mind that you'd know you were investing entirely in private markets securities but would have to trust completely in the administration of an independent reserve fund. That fund would never reveal the constituents of its portfolio options but would proffer risk and return metrics for each conceivable asset mix (though said metrics would have to be taken with the tablespoonful of salt that private markets' metrics require).
In these odd times, characterized by income inequality and a schizoid mix of economic confidence and concern, it's difficult to say that most would invest up to $3,000. And the reason why is because most retail investors, or even sophisticated ones, simply don't have the time or don't wish to conduct rigorous examinations of all their holdings. So, if the skin in the game isn't that significant, relatively speaking, for those fortunate enough to be able to invest say $3,000, I'm willing to bet many would opt to buy into that pool. As much as we like to think we are rational and sober-minded, at a certain point, we outsource much of our thinking and trust to hopefully reliable investment brands. A sovereign reserve fund that is collateralized by government-enabled means such as natural resources or the sale of nationalized enterprises to private hands—one that offers exposure to the entire gamut of private investment strategies—isn't too far from reliability.