Read this article and learn about:
- The growing role of private equity among asset managers
- How managing private equity portfolios is fundamentally different to traditional assets
- The ‘data-mess’ of aggregating data in a timely, accurate, and complete format for private equity
Thomas Meyer, LDS Partners
The growth of illiquid asset classes, such as private equity, precipitates the need for specific IT solutions. Intransparency and illiquidity are often seen as obstacles to remove but are, in fact, a source of private equity’s success.
Private equity is now the largest alternative asset class for pension funds after real estate. Despite this, the software for managing such investments has failed to keep pace. Things are starting to change.
Tightening financial regulation, increasing demands on pension funds for stakeholder transparency and a growing realization that larger private equity allocations present no meaningful liquidity risks are prompting a re-evaluation of the efficacy of existing systems. In addition, with increasing capital allocated to private equity the industry is becoming more competitive and efficient, requiring far more sophisticated approaches to portfolio management and more powerful IT system support. But the development and adoption of new technologies, never a trivial exercise, is particularly complex for private equity.
Investment in private equity requires patient capital
Long-term investors in highly illiquid closed-ended funds are essentially locking away their capital for 10 years or more. Private equity funds are typically organized as limited partnerships and designed to shield portfolio companies in their early stages and those in need of being restructured from disruptive market influences, and to assure these companies’ continued financing.
Figure 1: Typical private equity fund cash-flow pattern
Investing through funds managed by specialist managers has for good reasons become the mainstream modus-operandi of institutional investing into private equity. However, this successful model does not fit neatly into the wider investment landscape. A recent SimCorp poll found that more than half its users prioritized concerns regarding data, e.g., users want data collection portals and integration with third-party data providers. In private equity, these include Burgiss, Cambridge Associates, Preqin, as well as initiatives to create common data exchange platforms in the private equity industry, such as AltExchange.
According to 31% of SimCorp users, cash-flow forecasting for fund investments is the highest priority, which is an immediate consequence of the assets class’s illiquidity. Many view poor data quality and the lack of a market providing liquidity as a ‘bug’ and defect that needs to be fixed, before larger allocations can be contemplated. Paradoxically, both perceived weaknesses are in fact an essential part of private equity’s value creation proposition. It is worth spending some time on why this is the case.
Legalized insider trading
Private equity’s value proposition is the search for inefficient market niches, implying the need to work with proprietary but incomplete data. The difficulties associated with getting access to high quality data enable what is often called ‘legalized insider-trading’. For alternative assets such as private equity one outperforms by finding inefficiencies that the market has not yet uncovered. As inefficiencies in financial markets become exploited, investors need to continuously explore under-researched but potentially profitable niches in order to stay ahead of the game. In this process they are guided more by proprietary data than what third party data services can provide as information.
Investors in private equity aim to harvest the illiquidity risk premium that structurally illiquid asset classes may offer. In contrast to asset classes that may become illiquid as a result of financial turmoil and heightened risk aversion, investors in structurally illiquid asset classes, such as private equity and real assets, are aware ex ante of the risk they take. In fact, only long-term investors, whose liability profile allows them to lock capital in for significant periods (often 10 years or more) can take such risk. Here, funds basically serve as commitment devices that force investors to back long-term-oriented investment strategies even through difficult market cycles and thus enable the creation of successful and valuable companies.
The private equity investment process poses specific challenges, notably the different time horizon for illiquid, long-term-oriented and traditional assets which can be rapidly disposed of via secondary markets. How one manages private equity portfolios is fundamentally different to traditional assets. Investment managers in charge of traditional assets have a rich set of standardized and customized tools available and make use of IT on a daily basis. They can rely on high-quality data made available in real-time and with little effort. Transactions are highly standardized; speed and reliability of execution front-to-back are paramount. Market value and liquidity are almost synonymous and consequently trading in order to regularly rebalance the portfolio is the most powerful risk management tool.Even in public markets this may appear to be a glossy description, but the contrast with the situation in private markets is stark, nevertheless. In private equity there are comparatively few transactions, they are negotiated often over months and highly bespoke. Data is reported with a time-lag of months, is incomplete and of varying quality. Investment managers must ask their middle and back offices for analyses and reviews that require significant work to compile data from various sources. As a result, portfolio reviews, stress tests, scenario planning are done infrequently, typically on a quarterly, bi-annual or even annual basis. Designing the portfolio upfront is the major risk management tool.