Despite beliefs to the contrary, liquidity is not a pressing concern for private equity investors, according to Ludovic Phalippou, the University of Oxford Said Business School professor.
At least that’s the case for a “reasonable long-term investor,” he said. Phalippou drew his conclusions from a paper he coauthored with the Elise Gourier at ESSEC and Mark Westerfield at the University of Washington, which has just been published in the Journal of Finance.
Phalippou, who is perhaps the most prominent critic of private equity, said that liquidity should not be a problem for investors with up to one third of their portfolios invested in private equity and the rest in more liquid stocks and bonds.
“With two thirds of the portfolio fully liquid, the investor can absorb shocks,” he said on Substack, where he has just recently begun posting his views. “Bad markets, consumption needs, rebalancing. None of this forces fire sales.”
But, as Jeffrey Hooke, a senior finance lecturer at Johns Hopkins Carey Business School, explained, those allocations can change over time.
“After a couple of years, your allocation may be out of whack, and private equity (and other illiquids) might rise to 40 or 50 percent of the portfolio. That is ok for the investment staff, which can move on, but the beneficiaries can’t,” Hooke told Institutional Investor.
“If you want to rebalance after a time, that means going to the secondary market and taking a big haircut to NAV — currently around 15 percent,” he said. Another issue he cited is that “private equity is now taking 13 to 15 years to fully liquidate.”
Phalippou agrees there is a problem, and it’s what he calls the denominator effect, or the “commitment problem.”
“Suppose the investor wants one third in private equity, one third in stocks, one third in bonds. She commits 100, 100, 100. Bonds and stocks are invested immediately. Private equity capital is called later,” he postulated.
But “if public markets fall sharply before the PE capital is called, the investor suddenly faces a problem. Putting the full 100 into PE would push the PE share well above one third,” he said.
The professor advised investors to put only half — or one-sixth instead of a third — in private equity. If “stocks rise from 100 to 150, you deploy the PE capital when it is called, and top up your PE exposure using co-investments, secondaries, or directs.”
“If stocks fall from 100 to 50, you simply do nothing,” he added. “You do not overinvest in PE. You do not need to sell on the secondary market. You end up exactly where you want to be.”
As Phalippou sees it, “Illiquidity is not the central problem in private equity portfolio construction. Capital commitment is. And once you write down the math carefully, the solution that some investors have converged to in practice suddenly makes perfect sense.”
Hooke suggested another option. “Papers like this give the investment staffs of big LPs another excuse to buy into PE and other illiquids and justify their jobs,” he said. But “indexing is much better for the many Joe Sixpack beneficiaries.”
