Why Private Market Returns May Be Far Greater Than They Seem on Paper

Research shows private market investors have access to information that gives them a leg-up in the public markets.

Illustration by II

Illustration by II

Institutional investors have access to industry-level information through their private equity investments that often informs their investment decisions in the public markets, according to a paper from researchers at Purdue University and Illinois State University.

This is because some information that relates to how public equities are valued “resides in the folds” of non-publicly traded firms, according to authors Shrijata Chattopadhyay, a doctorate student of finance at Purdue, John McConnell, a professor of finance at Purdue, Timothy Trombley, an assistant professor at Illinois State, and M. Deniz Yavuz, an associate professor at Purdue.

The foursome suggest that institutional investors are the conduit of this information between public and private markets. In short, institutional investors’ interaction with both the public and the private markets means information learned in private deals often gets incorporated into public stock prices.

“The idea of the stock market itself is to ensure that… we should be able to incorporate as much information in the stock price as possible,” Chattopadhyay told Institutional Investor. “But, any new innovation that a private firm comes up with is still private information.”

Because institutional investors invest in both asset classes — public and private equities — they are capable of bringing in information that is not publicly available, information that other investors may not have, Chattopadhyay said.


To test their hypothesis, Chattopadhyay and his co-authors analyzed the returns of institutional portfolios that had positions in both publicly-traded firms and venture capital funds. VC funds have deep access to information about their investments: They know when one of their portfolio companies is innovating, changing lanes, or developing a new product that could upend the industry.

“VC funds are often actively involved in the oversight and management of the non-publicly-traded firms in their portfolios, providing the funds ample opportunity to learn about innovations developed by these firms,” Chattopadhyay, McConnell, Trombley, and Yavuz wrote. “In turn, institutional investors who invest in VC funds often have access to this information through formal information channels, such as quarterly reports provided by VC funds, and informal information channels, such as social interactions with VC fund managers. As a result, an information connection is formed between an institution and an industry when the institution’s VC fund invests in the stock of a firm in the industry.”

For example, Chattopadhyay said, if a small, private bank with venture capital funding develops a technology that helps measure a client’s credit score more efficiently, that information may be relevant to the banking industry as a whole. Its impact may even ripple to other industries. If institutional investors know about the new technology through their ties to the VC fund, they have a leg up when picking public companies to invest in.

Throughout the paper, the authors refer to the information connection between an institution and an industry as “connected industries.” The investments made in public stocks within connected industries are called “connected investments.”

In their analysis, the authors compared the returns from institutional investors’ connected investments with the returns from their non-connected investments and found that, after controlling for differences in industry returns, institutions’ connected investments saw returns of about 64 basis points higher per quarter — or about 2.5 percent per year — than their non-connected investments.

Chattopadhyay said this shows that institutional investors with connected investments aren’t just choosing the right industries in the public sphere — they’re choosing the right stocks within the right industries.

“If my VC is invested in biotech firms, I learn something about biotech firms and then I just invest in biotech,” Chattopadhyay said. “When we control for industry, it shows that, even within biotech, I, as an institutional investor, know which biotech firms would do better and which would do worse.”

When the authors controlled for investment risk, the return difference between connected and non-connected investments was even greater.

Daniel Celeghin, managing partner at INDEFI, an asset management consulting firm, said he’s not surprised by the paper’s findings. Celeghin said typically, large institutions allocate to third-party managers and have an in-house team that picks stocks. It makes sense that the information from one side of the portfolio would make its way to the other.

“In my conversations with some of these very large institutions that use this hybrid model, this process doesn’t happen accidentally. It’s part of a value-add,” Celeghin told II.

While institutions don’t go as far as demanding a “buy list” or asking managers to reveal their top stock picks, Celeghin said it’s generally expected that outside managers provide their institutional clients with research and additional insights and act as a “sounding board” when it comes to asset allocation.

Celeghin said there’s nothing necessarily nefarious about that. In fact, it makes sense: In terms of staffing, compensation, and resources, most in-house investment teams at large asset owners are at a disadvantage compared to private sector teams.

“One way to make up for that deficit is to piggyback on those private sector teams by asking them for insights or information,” he said.

Chattopadhyay reiterated this point. She said when most people think of the returns that private equity generates for institutional investors, they think of fund returns. But, Chattopadhyay argued that the returns that private equity funds generates in the public market through the information they provide to limited partners may be far greater than the numbers on paper.

“The returns from private equity cannot just be measured through the cash flows that the fund generates for you,” Chattopadhyay said. “You might learn something about other industries from them, and that’s a different sort of return that your private equity investment is generating for you.”

To bring their point home, Chattopadhyay, McConnell, Trombley, and Yavuz cited a quasi-natural experiment from the end of 2002 to the beginning of 2003. During that time period, state court rulings required public institutional investors to disclose more information about their VC funds’ investments through Freedom of Information Act requests. As a result, VC funds became wary of the information they shared with the institutions. Some VC funds, including Sequoia Capital, even asked institutional investors to pull their investments.

These rulings resulted in a clear disruption to the information pipeline between VC funds and institutional investors, and public funds felt the burn. During that time period, public institutional investors’ returns from connected investments were “disproportionally worse” than private institutional investors’ returns from connected investments, the authors wrote.

Celeghin calls this the “premium to secrecy.” Based on discussions with alternative asset managers, he said the degree of disclosure is a real consideration when taking capital from a public pension plan.

“Managers want to be the first in this trade or the first in this sector or this industry… and they don’t want to disclose too much of what they’re doing to their own investors, and they certainly don’t want their investors to disclose what their portfolios look like,” he said.

Chattopadhyay said the weaker performance after the information pipeline was disrupted speaks to the quality of information that VCs provide to their investors.

“It shows that VCs do, in fact, have relevant information, and if you try to regulate them, it might affect some of this information incorporation,” she said.