“An Analysis on the Current State of U.S. Private and Public Markets”
Another divide that exists in our economy is between the public and private markets. Over the last 10 years, capital has flowed heavily from public markets into the private market due to returns, risks, and fees. First, let’s analyze what makes a market “public” or “private” before analyzing the attractiveness of private investments.
If you asked a random stranger “what is finance?” they would probably respond with an answer including the words and phrases: “stocks,” “bonds,” or “Wall Street.” These all embody the public markets. The stock market is the most well-known public market. In the context of this article, however, public markets should be thought of as the role of a hedge fund in our financial system.
What is a hedge fund, you may ask? It is simply an alternative investment firm that pools money, or capital, from high-net-worth individuals to produce the greatest returns possible, or alpha, in the market. Hedge fund managers are compensated on the classic 2&20 fee structure: 2% of assets under management and 20% of generated profits each year. Many hedge funds will maximize returns by “betting” on the price movement on options contracts, or a derivative based on the underlying stock quote. Options can produce massive returns relative to a straight share purchase but also have an enormous downside. This investment strategy contributes to the high level of volatility and risk present in hedge funds. A core principle of finance is the risk-return tradeoff, which means that due to the higher level of risk, hedge funds have traditionally commanded higher returns. Investors also must pay a premium for liquidity and transparency that exists in the public markets and contributes to hedge fund returns.
Private markets, on the other hand, are known for being inefficient yet more stable. Similar to the term “public markets,” “private markets” represents a wide array of investments. This article, however, will specifically look at the characteristics of private equity firms.
The fee structure of private equity firms is very similar to that of hedge funds. Most private equity firms will charge 2% for assets under management and varying commission rates for carried interest, or a fee rewarding management’s decision to allocate a portion of the firm’s capital to that specific project. Most private equity deals are financed to some degree by debt which acts as leverage. This strategy increases potential returns by limiting the amount of equity exposure. For instance, imagine investing $10 million in a soda business through a straight, 100% equity position. Net profit after tax for the business is say $1 million which adds up to a 10% return, roughly speaking. Now consider financing the deal with only 20% equity by investing $2 million in cash and $8 million in debt through varying loan instruments. Net profit after tax decreases slightly to $600k because the equity stake was lowered, yet you still walk away with a roughly 30% return—3 times higher than your initial deal with 100% equity! This is the ultra-simplified model that many private equity firms use. Valuations on the private market are also generally much higher than those of public markets due to the aforementioned inefficiency. Firms are now willing to pay up to 40x EBITDA for an acquisition, far beyond the previous goal of 10x. Below is a graph demonstrating this trend.
From these descriptions, both public and private markets seem to be profitable and appealing, but capital flows, represented in the chart below, disagree with this statement. Private markets have become much more attractive over public markets for investors in recent years. A Financial Times article earlier this year stated that investors are “paying up for the privilege of investing with private funds, rather than getting paid for the risk of being stuck in untraded assets.” A Blackstone study supports this claim by stating that out of 230 surveyed institutional investors in large capital firms, 51% plan to cut exposure to public equities. Why is this though?
First, the current low-interest-rate environment is not ideal for hedge fund performance due to their fee structure. Most hedge funds will loan out excess capital overnight through a loan rebate agreement. The interest rate on these deals has been progressively moving towards zero in the last year as the Federal Reserve continues to slash the Fed funds rate.
Second, private equity firms have generated great returns in the last five years that are appealing to investors. The chart below demonstrates this performance relative to the S&P, real estate, venture capital, and hedge fund indices. This rate of return is closely tied to the inefficiencies of the private markets. In publicly-traded markets, investors are not able to pay below or above the equity value of a company due to real-time bid and ask levels. This is not the case in private markets as previously mentioned. Private equity firms are able to maximize these inefficiencies and discover returns that outperform those of hedge funds. Private equity investors will take synergies, or the greater level of value from two firms together versus separate, into consideration when valuing a privately held company to maximize future returns. The long-term role of private equity firms in their investments also generates alpha because of control over managerial teams and capital expenditure project decisions, to name a couple. Investors, such as hedge funds, in publicly-traded companies rarely have this power.
It is important to remember that private versus public market returns and “attractiveness” is highly-dependent on macroeconomic conditions, such as interest rates and the foreign exchange market. In the short-run, though, private equity looks to continue generating higher returns than hedge funds.
