One of the early contributions of Modern Finance was questioning the wisdom of active investment management. The empirical evidence indicated that active managers underperform passive strategies. While a finer analysis of the data subsequently demonstrated that some active managers are able to consistently outperform static benchmarks, the general principle that passive outperforms active remains, particularly for the high fee retail portfolios that the average man in the street is able to access. Curiously, it took 40 years for passive investments to assume their rightful role as the core of an investment portfolio(1).
The contemporaneous equivalent of the active v passive debate is the current infatuation with private asset markets. Private assets cover a range of investments such as venture capital, private equity, unlisted equity, partnerships, private lending, private placements, private real estate etc etc. Private assets all have the common feature that they are not listed on a recognised exchange which means that they are not publicly traded. This means that private assets are difficult to buy and sell and they are often described as ‘illiquid’.
The private v public debate centres on whether the expected rate of return on private assets is attractive enough relative to publicly quoted assets to induce investors to sacrifice liquidity. So far there appears to be a substantial premium to be earned in some private markets while others are dubious. For instance, early stage Tech-VC has generated long run risk premia of about 20% per annum compared with public equity premia of around 6%. On the other hand, while private equity appears to share a premium over public equity in gross performance terms, a lot of that gets eaten up in fees to the PE managers who undertake the investments. The bottom line is that private assets do offer superior returns versus their public counterparts but accessing these opportunities is difficult if you are a small investor.
While private assets make sense from a risk premium standpoint, their drawbacks are brutal. Investors are asked to lockup their capital for 10 years or more, information about the underlying investments is scant, investor protection is minimal compared with public markets, disclosure is optional, managers are gatekeepers, secondary sales are difficult to execute, regulators are at worst hostile and at best adopt a caveat emptor attitude. Lumped together, these drawbacks are the root cause of private asset illiquidity and therefore impede the public capital pool from crossing over into the lush private space…solve these problems and private asset markets will become more mainstream thereby challenging the dominance of the public markets.
The key to unlocking liquidity in the private space is understanding that the illiquidity stems from a confluence of factors rather than a single cause. Simply creating a token that sits on some cyber-exchange will not create liquidity since the other problems remain. For instance, the information asymmetries between sellers (who are often insiders) and buyers (who have no rights to ensure disclosure at any level on the actual investments) effectively drives the bid price well below fair value. If a buyer is scared of getting stitched up then he will bid low. Similarly, regulators need to accept that private markets are here to stay and, if the regulator is going to influence outcomes, then they need to ease the path to the public trading of private securities.
Solving the liquidity problem would take 3 simultaneous initiatives to my mind,
(i) Investors demand and entrepreneurs commit to high rates of continuing disclosure from private companies
(ii) Ease of price discovery and secondary transfer of private assets in some open marketplace
(iii) Regulatory tolerance of open markets with softer disclosure standards
Of these conditions, item (i) is the most important and suggests that private companies should voluntarily act like a public company when it comes to keeping markets informed. Entrepreneurs cite the relatively low level of continuing disclosure as a benefit of remaining private, thereby allowing them to focus on the business, but this is rubbish. Investors reward higher levels of disclosure with additional capital and higher valuations both before ipo and during the process of going public.
Just as ETF’s provide public vehicles which bring passive investing to the masses, sooner or later a public vehicle will bring private to the masses. Exactly what that looks like will make someone very rich.
US ELECTION PREDICTION SPECIAL
Long-term readers of this blog will be familiar with my theory that the great majority of swing voters in elections only decide who they will vote for when they are physically in the ballot room with pencil in hand. These voters are motivated by “Money and Mischief” – money in terms of which party or candidate offers them the best prospects and mischief in terms of pissing people off. So what is my prediction for next week’s US mid-term elections?
It is not fashionable to be a Republican in America. While the vocal left-leaning media fume at everything Trump says and does, it behoves the right-leaning Republican voter to simply sit quietly during dinner party debates or football afternoons with their Democrat friends. But the US economy is booming, the US President is ACTUALLY TRYING TO DELIVER ON HIS PROMISES and nobody seems to like Trump – publicly anyway.
So next Tuesday when the voters reach the polling booth and actually make their decision, the “Money and Mischief ” vote goes firmly to the Republicans. My prediction is an increased majority for the Republicans in both the Senate and the House – that will piss CNN/NYT/Washington Post/etc/etc off!
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(1) The first studies showing active managers underperforming passive benchmarks emerged in the 1970s but it wasn’t until the last decade that passive has become central. The reason for this is the emergence of Exchange Traded Funds (ETFs) that make buying a passive portfolio easily accessible to the average invest. The lesson here is that new investment ideas will only be embraced once the investment vehicle is publicly traded.