Tuesday, November 22, 2011

How Private is "Private Equity"?

Yesterday I was looking at the website of Insead (knowledge.insead.edu) where Cynthia Owens posted her article: "Private equity comes of age in China, India and Brazil".

Some colleagues and I are working on several projects that have connections into China, including one that is based in Brazil, so the article caught my eye.

One point I picked up on was this.  Private equity in China is very dependent on exchange listing (Initial Public Offerings) for investor exits.  India seems to be more of a Mergers & Acquisition play.  Brazil is more of a public markets play.

This got me thinking that "Private Equity" is really a misnomer.  These funds are really better described as "Pre-Public Equity".  It seems the US model is being copied internationally, with real access to capital being made available only to an Enterprise that commits to become funded through an Exchange (or to get sold out to another enterprise that is Exchange-traded).  The only real difference between public equity (i.e. exchange-traded financial instruments) and this kind of Private Equity, so-called, is timing.

The great strength of public equity, which is also it's greatest weakness, is it's laser-focus on a single point of value: the market clearing price.  This single-point-of-value dynamic is deceptively simple.  The truth is, the market clearing price is actually driven by a large number of converging dynamics, some of which are related, and others not.  Fundamentally, the price is determined by expectations for share price appreciation, which, in theory, are driven by supply-demand dynamics in the underlying commercial markets.  In practice, the layers don't line up so well.  And there is the added complication that the real, structural value of an exchange is to provide liquidity to investments that are not, of themselves, particularly liquid.  So, we have the core business of the exchange, which is arbitraging differences in the liquidity needs of different investors at different times, layered over the micro-economics of value creation inside the Enterprise, wrapped up inside the bubble-causing effects of macro-economic faith in historical trends as predictors of future value, all being spun around by the "herd mentality" of price point speculators, producing the herky-jerky up-and-downs, and booms-and-busts of the exchange-traded solution.

By comparison, rocket science is simple!

So-called Private Equity is not really an alternative to this.  It's more of a transition point into it.  Instead of guessing today what the market clearing price is likely to be tomorrow (the typical short-term event horizon of the average public equity stock portfolio manager) these Private Equity portfolio managers take what they like to call a long-term view: they look out 3-5, maybe 7 years, and guess what the market clearing price will become, out in the future, once a market is established for the stock.

That's not really private.  It's pre-public. And it's not really long-term.  It's more pre-term.  The fundamental structural problems remain, unchanged.

The Enterprise still cannot base decision-making on what is best for the business, in terms of profits, but also sustainability and what John Fullerton of the Capital Institute has nicely dubbed, "resiliency".  Enterprise still has to do what the Exchange demands.  Today.

Investors (not their professional management agents, but the actual, principal sources of capital available for deployment in expectation of earning returns by sharing in the value being created inside an enterprise) still find it next to impossible to achieve true programmatic alignment between investment goals (both financial and additional) and investment choices.  They still have to take what the Exchange gives them. At the moment.

Not much of an alternative, really.


I posted a comment on John Fullerton's blog at www.capitalinstitute.org that got cited yesterday as Comment of the Week.  Pretty cool.

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