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A New Approach to Pricing Market Access

Institutional investors should take a more creative approach to sourcing deals.

I’ve been expounding lately on the need to reintermediate the private market investment landscape. If you recall my post from last week, I argued that the frustration that many long-term investors have with their alternative assets, such as private equity or infrastructure, has little to do with the underlying assets. Rather, it relates to suboptimal access points.

As proof of this, let me direct you to some interesting research that unpacks the performance of various points of private equity access: Lily Fang, Victoria Ivashina and Josh Lerner in 2015 looked at seven large institutional investors’ PE programs, which included 390 direct investments between 1991 and 2011. The authors distinguished among three types of PE access: 1) funds; 2) co-investments with funds and 3) solo transactions that were originated and executed with no help from funds.

I expect that most readers would assume that performance was highest on co-investments with managers, then the funds, and last the solo deals. Am I right? No doubt that’d be the conventional wisdom. But, interestingly, what they found was the exact opposite. Co-investments with GPs were the worst performers, underperforming the corresponding funds they came from (due to adverse selection problems). The results also showed that the solo transactions outperformed the fund investments.

I think this is a remarkable and rather optimistic finding. Why? Because this suggests to me that Giants really can take advantage of their unique characteristics and networks to do deals that outperform the market. Granted, there are legitimate reasons that co-investments might be the worst performers. For example, larger deals (with less upside potential than small deals) often end up as co-investments because GPs don’t have the capacity in their funds alone. Still, GPs should underwrite all deals to a specific internal rate of return, so this really shouldn’t matter. It also doesn’t help explain why solo deals outperform funds.

Some of you might see this research as proof that Giants should develop in-house teams to do private equity solo. I’m not entirely opposed to that interpretation, but I’d remind people how hard it is to do private investing in-house (read this). As such, I’d like to suggest this finding be used to encourage Giants to take a more creative approach to sourcing deals rather than to in-source everything. I think they would be well advised to consider new access points that both minimize the internal burden and also secure higher-quality deals.

One popular method today is the use of platform companies. Another, which I’ll focus on on in the remainder of this post, is to set up peer platforms that allow Giants to invest together.

Rather than viewing solo transactions as truly solo, we should see them as investments alongside partners with which there are no formal asset management agreements in place. In other words, a “solo transaction” (in the parlance of Fang et al.) can, in fact, be understood as a co-investment — it’s just a co-investment within a syndicate of other like-minded investors. The World Economic Forum has taken to calling this partnership investing. It refers to the same thing. In short, this type of co-investment is about accessing high-performing “solo deals” through collaborative platforms, thereby reducing the reliance of Giants on misaligned GPs for required deal flow. The idea behind these platforms is to build the social capital of Giants in order to facilitate cooperation, collaboration and co-investment, specifically among peers. This is central to the reintermediation concept that we’ve been developing at Stanford.

This raises the question as to how Giants can pursue such partnership or peer co-investment strategies. The truth is that there’s not much in the public domain on these platforms and their success factors.

Until now, that is: In a new paper, Rajiv Sharma and I attempt to elucidate the collaborative investment platforms that foster co-investing among peers and aligned parties. I’m not going to rehash the paper here. I’ll simply say that it’s important we get this private market access point right, as most pension funds continue to see privates as a critical part of meeting their lofty return expectations. (Note: Whether this strategy is better than a public market investment with a few turns of leverage is for another post.) In my view, for private investments to deliver, the Giants are going to have to unpack the access points and really figure out how to maximize investment returns.

Until recently, most Giants hadn’t realized the clear and pressing need to rewrite the rules of engagement for private markets. But that perspective is quickly changing. (See PGGM’s big announcement this week.) This is due in part to the research cited above. But it’s really thanks to the recent scrutiny on fee and cost misalignment; the SEC investigation has been particularly shocking . . . and I understand from insiders that what we’re hearing in the press is the tip of the iceberg. It’s for this reason that I’ve been so focused on helping Giants find new ways to access private markets.

In sum, our new paper is concerned with how institutional investors can capitalize on their network to deploy capital in private investments through vehicles that provide more aligned, cost-effective and high-performance access. It’s less about disintermediating private equity managers and more about reintermediation ... don’t solo PE deals sound easier already?

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