Rudy Fichtenbaum enlightens further us on private equity; bottom line: "Essentially, private equity managers earn their high fees by concealing risk for pension staffers. And because everyone is getting paid, except the pension beneficiaries whose money it is, the show goes on."

The Real Truth About Private Equity and Diversification

By

Rudy Fichtenbaum

July 30, 2023

Some people, including Executive Director Bill Neville, think that private equity is negatively correlated with public equity, or at least he made this statement in his presentation to STRS members in Toledo. Less than perfect correlation between “asset classes” is how portfolio diversification works to lower risk. It implies that when one asset class is down, another asset class is likely to be up; this reduces what is known as portfolio volatility, aka risk. Since diversification is one of the main arguments used in favor of owning private equity, we should look more closely at this argument.

Before, doing that however, it is worth noting that Callan, STRS’s investment consultant, shows the correlation between public equity and private equity is 0.79. Although I am just a retiree living on a fixed income, (think Hyman Roth in the Godfather) and no longer teach econometrics, I don’t think that much has changed in the last eight years. The fact is that 0.79 is a high positive correlation. But let’s return to the world where we get to make up our own facts.

Recently Matt Levine wrote a column in which he showed that if you take the quarterly returns of the S&P 500 Index and lag them one year and then correlate them with the current year’s returns, the correlation is -0.23, which is a small negative correlation. In his column he points out that the underlying idea is a dumb one because you can’t buy last year’s stock market. At the same time, he believes the idea is instructive.

Consider the argument that private investments (private equity, real estate and private credit) are just like public stocks and bonds, except that the prices get updated less frequently. This means they intrinsically have a smaller realized standard deviation, which is how risk or volatility is measured. Think about it this way: stock prices change every day. In the long run there is an upward trend that reflects the growth of the economy, but along the way there are constant ups and downs. [If you gave your students only a midterm and a final exam, their scores would be more consistent than if you gave them a quiz each day.]

Private markets get marked-to-market (think Enron) on a quarterly basis. Exactly what is mark-to market? It means using an industry methodology to assign a value to an asset; i.e., they make up a number. If you think I am joking, think about the way real estate appraisals work. Appraisers are experts; they have a method or methods they use to come up with a value for a house. I just looked up the value of a house using Zillow, Credit Karma, Smart Zip, Realtor.com, and Redfin.com. Not surprisingly, I obtained five different values, but the spread between the highest and lowest values was more than $100,000! I also looked up the price the last time the house was sold. If I pick the lowest appraisal, the value of the house went up 41%. But if I pick the highest appraisal, the value increased 70%. These are actual industry accepted numbers; I am not making them up.

If I want to convince someone they should give me their money to invest in real estate because I am a real estate investment guru, which value will I pick?

Now let’s get back to the differences between public and private markets. Imagine something is priced only once a year. It will have lower volatility than something that is priced daily. But does that really mean that it entails less risk? Public equities can make people nervous because they are always going up or down. Is this an argument for buying private equities which apparently have more stable pricing? An apt analogy is seeing something that upsets you and closing your eyes. As the famous Japanese author Haruki Murakami said, “Closing your eyes isn't going to change anything. Nothing's going to disappear just because you can't see what's going on. In fact, things will even be worse the next time you open your eyes.”

If you are a pension director, you go to your Board and tell them diversification has reduced volatility in our portfolio because we have invested in two asset classes which are uncorrelated. Why are they uncorrelated? The reason is the misalignment in measurement periods between public and private markets. Translation: you are on a roller coaster. You can keep your eyes open or keep your eyes shut. In one case you can see you are going up and down and in the other case you cannot. But that does not change the objective reality that if you are on a roller coaster, you are going up and down.

Ultimately, what drives the value of something is what someone is willing to pay for it. For a company, whether it is public or private, a main driver is cash flows. If people think cash flows are going to be down in the future, stock prices will drop. But private investments in effect get to wait and see what happens to actual cash flows and then then put the best possible spin on things with mark to market.

When the stock market is declining, the value of private investments can appear to remain unchanged, so stocks and private equity appear to be uncorrelated, and many investment consultants will tell you that this is reducing risk. But if they simply opened their eyes, they would see that if there is a public business selling widgets and a private business selling widgets, and the market for widgets is tanking, they are both going to be in trouble. The only difference is in the case of public investments your eyes are open and you can see what is happening in real time, but with private investments your eyes are closed giving you a false sense of security. This is what as known as “volatility laundering.”

In his column Levine points out that for the first time since 2008-09 financial crisis, returns for private equity are down and were negative for the year ending March 31, which is used for year end reporting by pensions with a fiscal year that ends June 30. CALPERS (California Public Employees Retirement System, the nation’s largest pension system) reported that both private equity and real estate lost value last year.

Here is the last paragraph in Levine’s article which is the spin, i.e., the attempt to put lipstick on a pig. “Sure it’s bad that the private valuations are down now, but they are offset by the stocks being up. And last year they were up, which partially offset the stocks being down. It all works out great, even if private equity does not actually outperform stocks.” Ask yourself if this sounds familiar. Levine calls it a “stupid model,” and I agree. Essentially, private equity managers earn their high fees by concealing risk for pension staffers. And because everyone is getting paid, except the pension beneficiaries whose money it is, the show goes on. Let me know what you think.