Why buy public equities when PE is an option to invest in?
Hey monkeys, quick question that has bothered me for a while and resurfaced for some reason. I am wondering why institutional investors would invest in the stock market at all if the only way to realize a return is the stock beating expectations, while an investor in PE receives distributions throughout the course of the investment (if there are any) as well as the sale price at exit (or value from the would-be cash flow distributions if they have been re-invested in the company instead of being paid out initially) if the company performs according to expectations.
I recognize this may be one of the reasons PE is so popular for investors. I'm thinking about a DCF for two identical companies, one public and one private, same WACC, CFs, etc., and thus same EV and stock price. However, the IRR from investing in the private company is much greater just by holding the investment and it performing according to modeled expectations, meanwhile if this happens to the stock I receive no return.
I know there is a liquidity premium in the stock market, but with all the capital in the private markets, this seems like a steep price to pay given the lack of obvious returns. I would assume there is a % return priced into stocks as an asset class beyond what one accounts for when discounting down to EV and stock price so that these long-term return thresholds are hit and the asset class continues to attract capital. I guess you could also make the case that it is more a matter of having enough capital in the stock market so that everything is price correctly. Why does more money flow into the space if this is the case, is it to correctly price new companies that go public, etc.?
Anyway, hopefully this makes sense. Thank you all.
It’s not true that the “only way to generate returns is to beat expectations” in the public market.
Also, you frame PE investment performance as guaranteed, but it’s not. Just as a public company can do poorly, a PE investment can do poorly and not generate sufficient returns at time of sale.
Okay... what's the other way assuming that it does not pay dividends?
Yes, of course. That's not what I said. Performing according to modeled expectations. I am assuming both the private and public investments have identical risk profiles, ie likelihood of going south.
Dividends theoretically don’t affect returns, they just are a means through which returns are distributed at a given time.
The base case expectation, assuming a company performs according to market consensus estimates, is that a return will be realized by holding the stock. If that wasn’t the case then no one would buy it, and the price today would go down until that was the case. A stock being priced correctly doesn’t mean the expectation is that the price will never rise.
All good stuff. One more point. I believe the stock will appreciate even if it meets expectations as it gets closer to the higher forecasted earnings in the future. This should be what drives price increases. In other words the forecasted earnings that are implicit in the stock’s price today just moving up in time in the DCF.
Sorry for all the confusion!
Same way a bond’s value increases as it gets closer to payment date (obviously with some caveats)
The only way to realize gains or a return in the stock market is the stock beating expectations? Wtf did I just read lol?
Lol i don't think you understand how (successful) public market investing works.
You’re right! You figured it out!
The real question is why lock up your money in a PE fund and pay insane fees when by far the biggest driver of returns is the leverage they put on, something which you could replicate easily? PE are very good for GPs, for LPs this is far less clear
a study by the yale endowment says that adjusting for leverage, PE firms have abysmal returns compared to HF.
Would be curious the research but this is an interesting point. You can buy a PE like stock on margin and replicate the leverage. PE firms however will have better rates, better terms with lenders (less likely have to worry about a margin call situation), and have an equity cushion because of their access to capital. Also PE firms will have a control stake and so can make operational improvements and generate returns other ways that hedge funds can't. Also PE is such a diverse asset class (so is equity) that it's hard to compare. If I could give my money to a fund that invests in LMM and has returned 3x on average, obviously I would do that. Part of the reason to invest in PE is the same reason you would invest in real estate, bonds, equity, etc…it’s a different asset class and has different correlations, so there would likely be some benefit of diversification.
Any suggestions how to find this? Looked through google but must be missing some of the keywords.
Pulled PE’s Excerpt From
Pioneering Portfolio Management
David F. Swensen, Yale Office of Endowments
This is a great insight on the topic of PE’s aggregate underperformance relative to publicly traded securities. Highly recommend checking out the book in full too
“Leveraged Buyouts”
Leveraged buyout transactions involve private ownership of mature corporate entities with greater-than-usual levels of debt on their balance sheets. The high levels of leverage produce a correspondingly high degree of variability in outcomes, both good and bad. Leveraged buyout investments, in the absence of value-adding activities by the transaction sponsor, simply increase the risk profile of the company.
The increase in risk generally comes at a high price. Buyout partnerships charge substantial management fees (often ranging between 1.5 percent and 2.5 percent of committed funds), a significant profits interest (usually 20 percent), and a variety of transactions and monitoring fees. The general partners of many buyout funds suggest that they engage in more than simple financial engineering, arguing that they bring special value-creation skills to the table. While the value added by operationally oriented buyout partnerships may, in certain instances, overcome the burden imposed by the typical buyout fund’s generous fee structure, in aggregate buyout investments fail to match public market alternatives. After adjusting for the higher level of risk and the greater degree of illiquidity in buyout transactions, publicly traded equity securities gain a clear advantage.” “In fact, only top-quar-tile or top-decile funds produce returns sufficient to compensate for private equity’s greater illiquidity and higher risk. In the absence of truly superior fund selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.”
“Academic research backs up the notion that private equity produces generally mediocre results. Steven Kaplan of the University of Chicago Graduate School of Business and Antoinette Schoar of the Sloan School of Management at MIT, in an August 2005 study on private equity performance, conclude that “LBO fund returns net of fees are slightly less than those of the S&P 500.” The study covers the period from 1980 to 2001. Kaplan and Schoar’s results should dismay prospective private equity investors. Because the authors make no adjustment for leverage, the failure of LBO funds to match stock market returns adds the insult of higher risk to the injury of poor performance.”
“Because the riskier, more-leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, marketable equities win in a landslide.
A Yale Investments Office study provides insight into the additional return required to compensate for the risk in leveraged buyout transactions. Examination of 542 buyout deals initiated and concluded between 1987 and 1998 showed gross returns of 48 percent per annum, significantly above the 17 percent return that would have resulted from comparably timed and comparably sized investments in the S&P 500. On the surface, buyouts beat stocks by a wide margin. Adjustment for management fees and general partners’ profit participation bring the estimated buyout result to 36 percent per year, still comfortably ahead of the marketable security alternative. Note the extreme positive bias of the buyout sample. Long-term studies show that median buyout returns fall in the neighborhood of those produced by the S&P 500. In the sample of deals presented to Yale, buyouts crush marketable securities.*
“Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to-marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86 percent annual return. The risk-adjusted marketable security result exceeded the buyout result of 36 percent per year by an astounding 50 percentage points per year.”
“Mega funds often exploit their franchises by expanding into other (fee-generating) lines of business, including real estate, fixed income, and hedge fund management. The big partnerships devote more time to cultivating and nourishing limited partner relationships, the source of the funds (and fees). Less time remains for investment activity. Returns suffer.”
oh wow that's all that has to happen?
I think this entire idea of "you only make money by beating expectations" is on the right track, but not right per se. I think the only way to generate ALPHA is to beat expectations. If you agree with consensus expectations, you should at least generate a couple percentage point returns (more so market returns) on the stock. I might be wrong though, I haven't sat down and thought deeply about this.
Mathematically there’s a place for both in a well performing portfolio. The blend of multi asset classes aid in performance by controlling for beta and unforeseen risk.
Liquidity
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