Flows to private equity managers may be squeezing the illiquidity premium

Private assets are popular today as investors are reaching out on the risk spectrum for return. This behavior is always interesting to us since history shows it often leads to losses. We wanted to dig into private markets and see if excess returns are easily earned.

A brief overview

Today there are over $4.5 Trillion in private capital assets1 managed by almost 10,000 managers in the US. Twenty years ago, there were barely $500 Billion in assets, spread across 1,900 managers. Competition in these strategies has increased and the flow of money into these strategies has pushed up valuations for private businesses.

A market facilitates buyers and sellers coming together to transact. When a market is young and small, it tends to be inefficient. Skilled players can gain an edge. The outsized gains of the few attracts more competition and outside funds. At which point skilled players compete against other skilled players. Now edge is harder to come by. Increased competition drives inefficiencies out, making consistent outperformance harder. As a market matures, fees charged by the croupier (i.e. the broker) must come down.

This has already happened in public investment markets as investors learned how hard it is to outperform in this hypercompetitive arena. Michael Mauboussin’s research on the “Paradox of Skill” sums up this competitive dynamic nicely. The cost of chasing outperformance amidst high competition was the fees paid to the managers. In private markets, the cost will be higher as fees can be up to 5-6 times more.

The chart below is a replication of a promotional piece we received from one of the largest asset managers in the world, indicating the prediction that private equity returns will double those of public markets over the next 15 years.

However, our anecdotal experience in talking to investors is that most have not earned outsized returns from their private asset portfolios, and the data supports their claims.

The chart below shows the performance of public versus private equity over the past decade, which was an exceptional period for all forms of equity ownership.

Source: Bloomberg. Private Equity is the Cambridge Private Equity Index. Data shown is from Q3 2009 through Q2 2019.

Interestingly, in an environment that has been favorable for all equities, especially the more leveraged ones, private equity managers in aggregate have only matched the returns of public market indices. Furthermore, such indices of private strategies ignore many inherent biases, as noted in this Financial Times article.

Academics have researched whether the increased risks of illiquidity and leverage are adequately compensated. Others have written about how private market valuations have increased, which will inevitably lead to lower returns. Could it be that too much capital has already flowed into private markets? We were curious about how much capacity private equity has and took a cut at answering this question.