Many successful investors are known to have capitalised on the opportunities provided by the inevitable dislocations in financial markets. However, here is a perspective from Ted Lamade on how a segment of allocators are now constrained from benefiting from such events, thanks to a structural and significant shift in their allocations towards private markets over the past couple of decades.
“Fifteen to twenty years ago, the vast majority of portfolios were largely invested in public stocks and bonds. A lot has changed since then, mainly because investors have increased their allocations to private markets, materially in some cases. In fact, the Economist reported last week that the amount of money invested in or committed to private equity has “swelled from $1.3 trillion in 2009 to $4.6 trillion today” and that many allocators have more than doubled their allocations to private equity during this time. As an example, Brown University’s endowment had less than 20% in private equity in 2009. By 2021 it stood at nearly 40%. In some cases, the increase is even more pronounced. Look no further than The University of Pennsylvania. In 2002 its endowment had 2.3% allocated to private equity. By 2009 it had roughly tripled its allocation, but was still relatively modest at 6.3%. However, by 2021 it had increased its allocation to private equity by nearly six times to 36%!
For many investors (Brown and UPenn included), this has led to stronger performance and lower volatility (or at least the illusion of lower volatility). However, as with most things in life, this decision has its tradeoffs. In this case, given that these portfolios are less liquid today, the ability to rotate capital and be opportunistic has diminished materially.
How so?
Just look at how differently private and public markets react during these breaking points.
Private markets seize up. Anchored to valuations floated in more ebullient times, sellers go on “strike”. Banks that were once willing to lend at any rate get “alligator arms’’ and offer punitive rates, if they are even willing to lend at all. Meanwhile, private equity firms dedicate more attention to existing portfolio companies and less to sourcing, while limited partners request (or at least hope) that capital calls slow down. This leads to a situation where, as Tomasz Tunguz wrote in a recent post, the difference between where buyers and sellers will transact becomes “less of a spread and more of an abyss.” As a result, “the market seizes up, like a combustion engine without oil. No one trades. Investors pack their vests into a rolly-suitcase and head to the beach.”
Meanwhile, the public markets respond much differently. Sellers cannot strike because securities are traded daily, bank financing is not needed to deploy capital, less attention is required for existing investments, and capital calls are practically non-existent. The result is that while the ride for public market investors is much more uncomfortable, the opportunity to plant the seeds for future returns is significantly greater. Today is no different with most indexes down 20%+, some sectors down more than 30%, and one out of every five stocks in the Russell 3000 down more than 80% from their all-time highs.
The result, however, is that those with heavy allocations to private equity today are a bit paralyzed. While they shouldn’t expect a lot of capital calls from their managers, they still have to make sure they have enough in reserve to fulfill them if they do. Meanwhile, since private equity firms are slower to recognize losses, its percentage in many portfolios has only increased as a result of public market losses, which makes it even more difficult for allocators to rotate capital into beaten up parts of the liquid portfolio.”
He goes on to highlight key factors to consider for those who want to be opportunistic in public markets and finally ends with this gem on timing:
“In terms of when to deploy capital, I really can’t say it any better than Warren Buffett did in quote that Akre Capital highlighted in their recent second quarter letter in response to a question about whether this tough first half to the year is a prelude to more losses or the bottom.
“What is likely is that the market will move higher, perhaps substantially so well before either sentiment or the economy turns up. So, if you wait for the robins, spring will be over.”
Said another way, it’s impossible to know when the perfect time is to start investing into a downturn, so now is as good a time as ever to start planting those first seeds.
Otherwise just commit to privates and avoid the issue altogether.”
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