Private equity needs purpose (not debt)


Writing in the FT this weekend John Plender observes

Because asset managers in public markets are widely assessed against index benchmarks, they engage in momentum trading, constantly have to chase stocks that are rising strongly but in which they are underweight. This hobbles returns, inhibits long-term investing and leads to high volatility.

To Plender, taking a company private, improves returns, encourages long-term investing and stabilises the valuation of businesses. That’s why I want my pension invested in private markets.

To the ordinary person, there has to be a simple and understandable statement of why their pension fund should diversify from publicly listed to privately listed markets. John Plender’s explanation is that explanation. It explains the fundamental purpose of such investment.

Andrew Warwick-Thompson, posting on linked in , also has three reasons why trustees should invest in “illiquid assets”

 diversification premium; illiquidity premium; meeting their sustainability commitments.

Apart from being incomprehensible to the person on the street, these reasons lack the intuitive sense of purpose that I need to understand why my money should be invested in private markets. I don’t get why something that is hard to sell should be more valuable or that something is better for being different and I certainly don’t want my money invested to meet a target a commitment to sustainability.

It’s unfair to quote Andrew out of context and he’s making a wider point about the roll-back of Government policy on the just transition but his characterisation of private markets talks to professionals and not to beneficiaries.

His  reasons for investment  are theoretical and don’t appeal to common sense. As a business owner, I value long-term shareholders who back me to do my job over time, I can see how investing in the fundamental value of a business rather than a market trend, is likely over time to produce better results and I can see why I might not want the value of my investments to be dependent on the day to day sentiment of market traders.

But I would only take that view , if I had no wish to have my money back any time soon, if I was confident that I had people on my side who understood long term value and if I was confident in the underlying valuation process.

Too much theoretical bollocks.

In short, I am looking to be able to explain why money is invested as it is in terms of purpose. While my trustees can gabble on about illiquidity premia and TCFD, I want to know that my money matters and that I am getting rewarded for being a good long-term investor. I don’t want theoretical bollocks, I want purpose.

The reason for this distinction forms the body of Plender’s argument. There are two ways to make money out of private markets and they can be differentiated by “theoretical” and “fundamental”.

The theoretician assesses potential reward based on the financial engineering of debt instruments to generate an internal rate of return. So money can be borrowed at a low rate to get return at a much higher rate by multiplying the fractional advantage from a share purchase by the “leverage” of borrowing. Here there is no productive activity in the sense that a worker or a manager of a workforce would recognise it, things are not being done better within the investment.

The second way of doing things, we can describe as productive finance, where the investment actually improves for the money it receives by way of new shares purchased. The focus of the owners of these shares are not looking to extract return by means of financial engineering, they are looking to accelerate growth in the underlying investment.

Which is why, I talk here of “theoretical bollocks” because unless a trustee can describe to me the reason for making an investment in terms of its purpose, I’m really not interested. I simply don’t believe that something is more valuable because it is illiquid or different and I’m not interested in short-term “regulatory arbitrage”. as a long-term investor.

Especially now!

Now is not a good time for the theoreticians. Plender explains

Refinancing debt in private equity portfolio companies at vastly higher rates of interest than when leveraged buyouts took place has been challenging. Private equity managers have increasingly been driven to esoteric, highly risky forms of debt financing to keep the corporate show on the road.

Pension funds that have been buying into private equity on the basis that returns are driven by interest rates aren’t really buying equity at all, they are buying the bonds that funded the equity and they await the same fate as befell them last year when they borrowed to buy gilts (to buy equities). They are having to write down their private equity assets because they cannot be refinanced at the rate of borrowing at which they were bought – on the back of theoretical bollocks.

But pension funds do not have to borrow, they are capital rich and in any case are over-invested in debt. Instead of investing for return (the AWT formulation) they should be invested for purpose (the idea behind productive finance).

Plender concludes that since the pandemic, public listed markets have raised a record $626bn in pure equity funding. This presumably is from the prosaic long-term investors rather than market-traders. The question facing those who command the wall of money coming into private pension schemes from payroll out of de-risked lifestyle programs, is how to capture the potential of private markets.

With the re-sell value of leveraged private equity funds falling like a stone, now seems as good a time as any to get going. Trustees may not get the IRR generated by cheap borrowing , but they will get the long-term growth from investing in real assets with a clear purpose.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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