Massimo Saccone, a private equity specialist, explained to aiCIO how the teachings of Italian astronomer Galileo could help investors assess private equity performance and give them – and their GP partners – more options for their portfolios.
aiCIO: What has Galileo got to do with private equity?
Massimo Saccone: We use the Galileo analogy to make investors look at and invest in private equity funds in the context of the “investable universe”. It was actually Copernicus who formulated a “revolutionary” astronomical theory but it was Galileo who became famous for having supported the new astronomy based on actual observation and supported by well-documented experiment and facts.
Using that analogy, for decades the perception about private equity was that it was working. The Galilean moment comes with the recognition that something in that perception is broken.
We are saying that the issue is not with the methodology for managing private equity, but that investors should change the perspective from which they look at it. What we are proposing – using the Galileo analogy – is: a) Private equity should be treated like every other asset class b) To do so, when you compare asset classes, it should be apples against apples. If you use the internal rate of return (IRR), you are comparing pears against apples.
Footnotes in reports from major consulting firms, industry associations, and data providers on private equity show it has outperformed listed equities but say “listed equities are time-weighted, private equity is money-weighted”. So they know the problem, but they haven’t questioned it.
The flawed technical assumption in the IRR is the reinvestment rate. If the IRR is high, you look to have done better than you actually have – the money that flowed out of the standalone private equity transaction is just that – out. It is in cash and not reinvested. Same thing on the downside. If you are losing 20% negative IRR that money falls out, but it is counted as being reinvested and accentuating the loss.
aiCIO: Why is it important now for investors to update this measurement?
MS: We are not saying private equity is not outperforming – it actually is – but investors should start measuring things correctly. As liquidity and risk management become priority agenda items for private equity investors, if you can’t measure it, you can’t manage it.
If you want liquidity or you need to manage risk you need a price. There has to be some sort of transparent price formation mechanism that is typical of other asset classes including complex stuff like CDS, which are no less complex than private equity. If you want to price, you need to compare and take two things you think are similar. We all agree private equity is equity but we weren’t using that comparison. So the 300-400 basis point outperformance that has been typical of many reports was based on an imperfect measure.
Even if it isn’t a forced sale, you have to have an indication of what something is worth if it has to be sold tomorrow – that is going to become mandatory because of regulation. Every other benchmark for private equity has lots of data, but it is calculated in the wrong / unrealistic way and because of this it is not investible.
A lot of people are saying private equity now has to earn its place in the portfolio. They have to measure the premium and then decide whether it is adequate for the risk-taking.
Going back to Galileo, you have to correctly position the stars to measure the time of the day.
Galileo was a fervent catholic and in spite of his experimental approach to the sciences was able to avoid trouble for a while. He then found the evidence that made the Copernican revolution undeniable and ended up being condemned as a heretic. It’s the same with us. This is the opposite of an attack on private equity; it’s actually a way to prove there are very good ways of money making – and puts investors in a position to understand this better and to decide accordingly.
aiCIO: Trying to tell private equity bosses that they are not the centre of the universe, do you think they will take that well?
MS: This is a “side-effect” of the analogy but is just matter of perception. The fact is that LPs are becoming more selective, not because they are being choosy, but they have to face their own evolving internal needs. And they will need to change their asset allocation over the next ten years.
Private equity managers are quite good at figuring out the intrinsic potential value of an asset. What they can’t know is when they can realise that value. This is a market valuation element that investors need to consider and can only properly evaluate in time-weighted terms to take actionable decisions.
If, for example, the market goes down, the spread that the movement creates between intrinsic potential valuations and market valuations may widen so much that from a risk perspective an investor may say: “A 10% annualised spread between this investment and the market, for me is unsustainable. I can hedge my market exposure. If I can also lock in not 10% but 5%,” a 5% annualised spread versus the market, say over seven years, is an awful lot of money even if it implies a discount of the NAV and perhaps limiting the upside – “then at the maturity of the contract, from an asset-liability or risk management standpoint, I will have realised market plus the spread that I have locked in.” That’s helpful and that’s the way it is done in every other asset class apart from private equity.
Preparing derivative contracts that allow the investor to do so is what we are working on and can only be achieved in an apple against apple environment.
aiCIO: How is private equity different to other asset classes that has meant it has been measured differently?
MS: For the few years of the portfolio formation period there is blind faith and there’s some market risk that you inevitably build in. As time passes managers start expressing themselves vis-à-vis the intrinsic value of their portfolio. That is when institutional investors can start using this information. Then you can start taking decisions on taking on or getting rid of risk on some funds synthetically.
If you see a divergence with a fund outperforming as the market suddenly falls, is this fund throwing out a lot more cash than the market? If the answer is ‘no’ -it takes two minutes looking at aggregate cash flow and EBITDA growth data. Each GP has a different style with regards to valuations and builds different amounts of ‘hope’ in his projections. Managers have to estimate the value of the company, when to exit the investment taking into implicit account the future market conditions – that’s where “hope” comes in.
Sometimes they are right with the valuation and timing, but their assessment of hope and market conditions is not enough. Are you, the investor, comfortable with the eventual difference in expectations or do you want means to lock in at least part of that value to meet your own personal objectives for risk management?
aiCIO: How likely is it that the adoption of the model will happen? Who will be the first mover?
MS: Early adopters are likely to be LPs. We have already had discussions where the concept has been well received. But also GPs can benefit from our synthetic approach. Our solutions start to be available when the managers close their funds, so if there is something synthetic that can help an investor manage exposure without losing a lot of money just because they need a forced sale in the secondary market, the GP can show there’s an additional layer of flexibility.
aiCIO: And will this create new products?
MS: Everything that has been done with fixed income can be done for private equity. It is about cash flows – and predicting these cash flows. Portfolio diversification plays an important role.
By using this tool you can rebalance the weight in the decision making between LPs and GPs in the secondary market. Along with the Galileo analogy, this may not sound great to the GPs, but an efficiently functioning market in the long run is good all round. The inefficiencies that the GPs should focus on should be at the level of the investments not at the level of the market.
We owe investors the respect to do this. Part of the ethos of ‘sustainability and responsibility’ is putting all participants in more harmonic positions.
If an investor can see and understand the risk-return profile, some of the issues around transparency become irrelevant. Adopting time weighted measurement terms, the investor can see if the investment is performing like a listed equity, potentially with less volatility and with a higher return, and, having the tools to manage the relevant risks, he is likely to have less to worry for the next six-to-eight years.
Massimiliano Saccone, CFA, is the founder and managing partner of XTAL Strategies, a private capital fund’s advisory and investment firm focused on delivering innovative investment, risk management and liquidity solutions to limited partners and investors. He has over 18 years of financial industry experience gained in senior roles of major global investment management firms and consulting companies. A Chartered Financial Analyst, an Italian Certified Public Accountant and Auditor, Massimiliano has a Degree cum laude in economics and commerce with a major in advanced financial mathematics from the University La Sapienza of Rome and a Master in International Finance from the Collegio Borromeo and the University of Pavia.