Invest in the Best
By: Steven L. Miller
Tags: Equity, Private Equity, Finance, Stocks, Investing

Top Private Equity Managers are the Only Ones Likely to Achieve Return Expectations

Plus 4 More Lessons Learned From Public to Private Equity in the United States: A Long-Term Look

The last 25 years have seen a shift in US Equity market structure. Companies are staying private longer because capital is more readily available.

Capital is readily available because of strong historical performance for private equity assets.

Increases in assets under management are inversely correlated with performance. As Private Equity managers AUM increases their performance decreases.

Only the best managers have demonstrated the persistent ability to realize better returns than public equity markets.

Lesson 1 — Ratio of tangible to intangible assets has flipped

the mix of tangible and intangible investments has changed over the last 40 years. In the late 1970s tangible investments were nearly double those of intangible investments. Today, intangible investments are one-and-a-half times larger than tangible investments.

The shift from tangible to intangible assets has had a meaningful effect on the mix between public and private companies. That many young companies have less capital intensity means they don’t need to go public to raise capital…

the economics of information goods, combined with the concentration of traditional industries and the outsourcing of low-value-added activities, means that a handful of leading companies earn much higher economic rents than their competitors and businesses of the past.

Lesson Learned

High valuations for leading companies may be justified. If their is additional scope for outsourcing low value add activities and the large economic rents they extract are defensible.

Lesson 2 — Price discovery is stunted in private markets

there are now numerous examples of companies that have not lived up to their high valuations. These include Theranos (which peaked at $9 billion and later dissolved) and WeWork (which went from $47 billion to $8 billion in 2019). Raising a substantial amount of capital implying a high valuation does not by itself confer success.

Price discovery is stunted in private markets, as only optimists invest and there is no mechanism for pessimists to express their view. The sunlight of an IPO can be the best of disinfectants from overvaluation and can improve productivity. From 2011 through 2019, about one-third of the companies that went public had a valuation below that implied by the final round of private financing.

Lesson Learned

High private market valuations do not imply future success as a public company. Once public, companies must demonstrate the ability to grow profitably to be attractive to public market investors.

Lesson 3 — Headline Private Market Valuations Are Routinely Higher Than Actual Private Market Valuations

Academics who studied unicorn valuations found eight share classes per company on average.

These professors analyzed the financial terms from legal filings and found that reported post-money valuations for unicorns are roughly 50 percent above fair value on average, and for about 10 percent of their sample the valuation was double fair value. Nearly one-half of the 135 companies in their sample lost unicorn status after they made all of the appropriate adjustments.

Lesson Learned

Investments terms in private markets are not standardized. Incorporating these terms into valuations results in lower multiples than the headline numbers reported.

Potentially explaining why many companies go public at a lower valuation than their implied valuation while private.

Lesson 4 — Compensation Structure Impacts Performance

The timing of general partner compensation also appears to be a relevant factor in determining returns for venture capital funds. Returns for limited partners are higher before and after fees when the agreement is to pay general partners on each deal rather than deferring carried interest until the fund has reached a benchmark return. As with most corners of the investment world, there will be pressure on fees for many buyout and venture capital firms. Similar to active managers of public equities, firms that demonstrate skill will be able to charge above average fees. But investors will likely challenge the lower tier of the industry to lower fees.

Lesson Learned

More frequent payments appear to lead to better results for the Limited Partners in Venture Capital funds.

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