Truth on the Market, that I was once again led to via Abnormal Returns, discusses the quandary of interim valuation of private equity portfolio in the context of the growing clamor for private equity "regulation." Two issues are presented as problems. 1. The lack of true time-series volatility information for private equity as an asset class. As to this issue Bartlett cites no less than David Swensen, Chief Investment Officer of Yale's endowments, who quips:
By masking the relationship between fundamental drivers of company value and changes in market price, illiquidity causes private equity’s diversifying power to appear artificially high.
2. Valuation during the course of the investment is difficult, because of the lack of data points to measure progress during the lifetime of the firm. On this point Mr. Bartlett says:
Consequently, it’s not possible to obtain a current value of these securities as you would for, say, shares of IBM. Moreover, many of these companies—particularly start-up companies—lack reliable financial metrics that can be used to value the firms using other valuation techniques (e.g, discounted cash flow analysis, etc.).
Is the answer "mark to market" accounting a la Enron? Bartlett isn't totally convinced. I, however, am totally puzzled by this line of thinking.
As to the first point, I am not sure why the inability to value a given single fund in a mid-stream has a deleterious effect on the ability to measure standard deviation for the asset class as a whole. In the buyout example, first of all, it strikes me that results from a fund of funds composed of multiple buyout funds of multiple vintages will give a consistant stream of return information that is better representative of the asset class. As each fund starts disbursing in its later years these returns become measurable on the upside. On the downside, impairment is often a triggering event. Unless you were constructing a particular portfolio of single buyout funds (which I suppose Yale may well do) I don't know why you would even want to collect individual fund data. That makes a poor sample size if what you are looking to do is measure correlation figures for an asset class. I would think you'd have better luck using a reach of the segment of funds you were interested in, or, perhaps, viewing returns over time for a family of funds. If you properly layer your investment among multiple vintages you mitigate, to some extent, the lower volitility measurements of your early capital investments. While two to three investment sis are the 1-3 year early "black hole" of zero-volitility, 4 or more others (assuming you have one of each vintage year for 7 year lifespan funds) are showing results and distributions.
As to the second point, being unable to value particular portfolio firms within, say, a buyout fund, doesn't really strike me as a severe handicap. If you've invested in a private equity fund you are tied in for the duration with lockups anyhow. You can't effectively exit your money so monitoring or marking your own investment "to market" is silly. Your funds in the find are just as illiquid as the fund's investments in portfolio firms. If you weren't comfortable with that you never should have invested in the fund. Marky Mark to market? Sexy, but dangerous.
Once again, this drive to make highly granular observational assessments of what are essentially long-term investment vehicles threatens to turn the buyout world into the quarterly naval gazing, short-term, noise knee-jerking morass that are the public equities markets. This defeats the entire purpose of the private equity vehicle: A long-term investment (hence the lock-ups) for sophisticated investors in an area where long-term patience is required to realize superior returns. It is an alternative to the what have you done for me lately public markets for a reason.
In my view two external pressures threaten to cause serious damage to a market that, properly managed, imposes significant efficiency gains.
First, the flipaholic or "div and dump" or "div and flip" or "div and shiv" (give yourself a dividend and stick a shiv in between the ribs of the public) trend in large buyout funds to quickly lock in minimal gains via public debt issuances coupled with massive special dividends and then, having significantly limited downside risk, lock the unit basically in status quo "don't fuck it up" mode until a public equity market exit can be arranged. (I tend to think Burger King's CEO bailed because he was so disgusted with this practice, but I am probably leading myself down the prim rose path here). This trend has turned buyouts into a very risky, short term affair. It was never meant to be. The era of "financial structure only" returns for buyouts is over. In the 1980s, break-up was the exit. Today it is the public debt issuance and IPO. What happened to management excellence? Too hard. Too speculative. To risky, I suppose.
Second, the blurring of the line between "private equity" and "hedge funds." To my way of thinking this confusion originates on the hedge fund side. Certainly buyout shops don't want to be associated with hedge funds. Rather, I think the Madonnaesque hedge funds have reinvented themselves as anything but hedge funds. Venture capital, private equity, buyouts, mezz funds. Anything.
Both of these are symptoms of the larger problem. Too much money in the asset classes. Overly high expectations on return by a spoiled market saturated with Business Week articles about the super-rich managers taking billion dollar payouts.
I heard a senior person at Centre Partners Management comment that $750 million was about the upper limit for buyouts before you started to be not in the business of doing deals but rather in the business of just farming out money. I think that's about right. Focus. The leveraged desk at a big hedge fund we take debt from is five people. (That same firm has six full-time lawyers on the payroll). They have deployed something like 1.5 billion in high yield debt in LBO deals. How in the world are they going to monitor that? I suppose the hedge fund would call that efficient. For my part, I'm happy to take their debt because they don't do much monitoring. It is not that I dislike monitoring, but they sure are easy to deal with day-to-day.
Didn't we learn in the 1980s that unfocused conglomerates don't work particularly well? Why are we running down that road again, with hedge funds, with Google? Management fees, perhaps? We are long past the point where the management fee just barely pays the bills at a fund and you have to find upside to get wealthy. The incentives to bloat assets under management are simply too significant now, I think.
All this has prompted me to start a new internal project. How will we, at Sub Rosa, best capitalize on the detritus of large, overly diverse funds in a few years when they collapse under their own weight?