When it comes to investing, particularly during market downturns, it’s hard not to think of plus ça change, plus c'est la même chose — the more things change, the more things stay the same — attributed to 19th century French author Jean-Baptiste Alphonse Karr.
It’s 2022, and things have changed a lot since 2008, the last prolonged market crisis. Today, we have war in Eastern Europe, supply-chain bottlenecks from a pandemic, a rate of global inflation not seen in decades, and commensurate deglobalization.
In 2008, though there was financial turmoil, there was not a war of the current magnitude, supply chains hummed along nicely — other than suffering from diminished demand — the housing bubble burst, and, despite all of this, globalization persisted.
Still, some things have stayed the same. A commonality in both periods is that most risk-seeking markets — think equity, credit, and other markets — were and are down materially. Another thing that is startlingly similar is the quagmire that sophisticated asset owners have gotten themselves into, specifically being overweight private equity.
Of 2008, I remember investment committee meetings where public-equity managers were down materially, even as private-equity managers were down marginally at most. Even more remarkably, some of the public and private managers owned companies and competitors in the same industries, including autos and financials. I couldn’t help but wonder how public companies were down massively and often bankrupt, yet their private peers, including ones that had been taken private not long before, were only down a small amount. Ultimately, public-company values caught up to private ones, as that huge gap represented only a lag and the smoothing effect.
However, before this catch-up, many, if not most, of the world’s asset owners, including many I think highly of, had a prolonged issue with their strategic asset weighting. A confluence of factors resulted in private equity (and some other illiquid asset classes, but for the sake of brevity I will constrain this article to private equity) exceeding the strategic asset allocation set by the institutional investor.
Generally, this came down to a number of factors, including the outsize performance of private equity during the bull market from 2003 through 2007, then the subsequent lag in those valuations reflecting the public markets. Other reasons were the public-market selloff in 2008 — which resulted in the value of equity, credit, and fixed-income positions falling precipitously — and the so-called denominator effect. The denominator effect describes a situation where the delayed valuations of private equity divided by the value of public-market positions that are priced daily increased as a percentage of the total portfolio — and typically well above an allocator’s strategic weighting.
Fast forward to today and it all sounds familiar. Based on the conversations I have had with world-leading asset owners and consultants, it is effectively the same dynamic.
In light of this predicament, what options does an asset owner have?
- Passively accept the overweight, with the view that private-equity valuations will ultimately converge down or public-market valuations will converge back up. Over time, the problem solves itself. Clearly, this is a path-of-least-resistance solution that will be quite appealing to many CIOs (and boards).
- Increase the strategic weight, which effectively solves the issue, particularly if one has an exogenous view that one wants to have a higher weighting — i.e., due to ex ante return expectations or other factors. This likely requires board approval, which can be time-consuming and might be rejected.
- Increase the tactical weight, knowing that over time one can take the tactical weight back down. Though I would caution that a material percentage of allocators may not have this flexibility, and this too is likely subject to board approval, which may or may not transpire.
- Sell private-equity positions in the secondary market. That said, if I am not wrong, there is likely a glut of sellers, all due to the same or similar reasons, and a dearth of the largest buyers in the opposite position. That, in turn, does not bode well for the market-clearing price and likely results in a material discount, which in turn results in a crystallized down mark, realized loss, from the prior valuation. In addition, though the secondary market is more liquid than it has been historically, it is hardly liquid compared to heavily traded public markets, and is particularly illiquid for the larger asset owners. All of this is of course not appealing to asset-owner CIOs and boards.
- Allocators ask private-equity managers to slow down or stop capital calls. During 2008, this did happen among the most sophisticated asset owners, including top endowments and foundations. However, this is not ideal for private-equity managers for many reasons. For one thing, the managers are effectively on a treadmill, where their business model is predicated on raising capital, deploying it, and raising new vintages of funds on a periodic basis. This is disruptive to that cycle and the economics of their business. Managers are also averse to this because they very likely have a pipeline of new companies they are in due diligence with and on the cusp of investing in. Overtures to terminate these new investments would be poorly received by company management and would diminish the private-equity firm’s credibility in the market for future transactions.
- Allocators terminate commitments to new vintages of funds. Though this may seem like the proverbial no-brainer, it is not. To borrow a sports cliché, the top private-equity firms effectively put allocators in the penalty box when they do this. The following vintage, when things have worked themselves out and the allocator is looking to invest, the private-equity firm will have, to use an airline analogy, downgraded them to the bottom of the list for their scarce capacity, and in turn upgraded those that did re-up to the new vintage.
- Ask private-equity managers to mark their funds on a quarterly basis to more accurately reflect lower public-market valuations of peers and competitors. Though perhaps a theoretical, idealistic asset owner (and board) that had the benefit of not being sensitive to short-term returns or losses could do this, I am hard-pressed to think of an actual asset owner (and board) in this luxurious position. Although this option is not technically impossible, taking it is extraordinarily unlikely and largely unheard of.
So where does that leave asset owners that are largely overweight private equity? I believe the solution is to implement a blend of some of the aforementioned options. Some will increase their tactical and strategic weights, while others will implement moral suasion to ask the managers to at least decelerate the magnitude or speed of capital calls. A small percentage will sell at a discount in the secondary markets. And others will diminish or eliminate commitments to the next vintages. As stated, I do not expect many to proactively request more aggressive markdowns of their existing portfolios.
In summary, despite the changes in geopolitical and supply-chain issues between 2008 and 2022, the market situation and asset owners’ strategic overweight of private equity has largely not changed. As Karr stated over a century ago, the more things change, the more things stay the same.
Michael Oliver Weinberg is an adjunct professor of economics and finance at Columbia Business School, where he teaches institutional investing. Formerly, he was head of alternative alpha, a member of the investment committee, and a board member at APG, a €600 billion ($620 billion) pension provider.