The Hedge Fund Transparency Act sponsored by Senators Charles Grassley and Carl Levin reportedly contains a provision that would require private equity firms to publicly disclose the fair market value of their investment funds. Together with the recently adopted FAS 157 mark-to-market accounting standard, the general trend toward fair value reporting and public disclosure is being viewed as a negative for private equity firms. Nothing could be farther from the truth. If history is any guide, a move to more disclosure can be a catalyst for a new wave of growth for private equity that will usher in its true “Golden Age.”
When discussing private equity or leveraged buyouts, people tend to focus on “private” and “leveraged” rather than “equity” and “buyout.” The latter two terms, however, more accurately describe the role that the private equity asset class plays in the capital markets. Private equity is a form of activist investing that seeks to add value by acquiring and growing or restructuring companies in a way that public management would not. Private equity seeks to capture returns in excess of the market return by trading the liquidity of the public market for the control premium of the private market.
The Value of Control
According to Cambridge Associates, over the 10 years ending September 30, 1998 2008, the private equity asset class returned 11.8% versus a return on the S&P 500 of negative (1.0%). Private equity is a form of equity just like public equity and the returns, in an efficient market, shouldn’t be that different. Much of the return premium in private equity is due to the control premium, where shareholders and management become more closely aligned. In a properly functioning equity market, the presence of a large, liquid and active private equity sector would force public company management to become more aligned with the long term interests of shareholders.
If the private equity industry was to actively seek out SEC reporting standards, it could do three important things. First, it could broaden its investment base beyond institutional investors. Second, it could move to a system of “permanent capital” more like publicly-traded closed end funds. Third, it could broaden its scope to include taking large, active stakes in public companies where private equity funds could bring their strategic expertise to bear and creating a hybrid public-private ownership system that captures value from both liquidity and control.
These three steps would mark a maturation and institutionalization of the private equity industry and allow it to continue to grow. A convergence of the private equity and public equity markets could arbitrage away the excess control premium in the public markets, increasing the value of public companies and narrowing the return differential between public and private equity.
The Value of Liquidity
Given the big surge in private equity investment over the past several years and the recent market turmoil, it is projected that private equity commitments will decline over the next decade. Traditionalists will welcome the decline in commitments as a way to undo the “too much money chasing too few deals” problem and restore a high return premium. The more forward-looking attitude would be for the industry to instead seek to maintain high levels of asset allocation to private equity and position the industry for further growth.
The key to maintaining growth in private equity is to reduce the liquidity premium relative to public equity. The events of the past several months have demonstrated that liquidity is highly valued for a good reason. Private equity would do itself and its investors a great service if it can increase the liquidity of the private equity secondary market.
The more transparent the information about the underlying portfolio investments and their valuation methodologies, the more likely secondary investors are to bid prices closer to the reported net asset value (NAV) of the fund. The closer the secondary bids are to NAV, the less risk there is for a potential investor to commit to a private equity fund, and the easier it will be to attract assets to the class. Private equity should therefore embrace the SFAS 157 mark-to-market accounting standard so that the reported NAV approximates the true market value as closely and as rigorously as possible.
Private equity is now in a similar position that the public equity markets were in around the time that the SEC was created in 1934. SEC reporting requirements were resisted at first; but eventually by increasing transparency and trust in the public equity market, the asset class was opened up to the general public and valuations have increased. The opportunity is here, all private equity has to do is seize it.
Tyler Newton, CFA, is a partner of Catalyst Investors, a growth private equity firm in New York.