Professor Greg Brown is the Van and Kay Weatherspoon Distinguished Professor of Finance at the University of North Carolina’s Kenan-Flagler Business School, a former asset management firm research director and serves on the board of directors of the Chartered Alternative Investment Analyst Association. He is also founder and research director of the university’s Institute for Private Capital and a member of the Private Equity Research Consortium advisory board. His research focuses on alternative investments, including hedge funds and private equity funds.
He spoke to CIO Executive Editor Amy Resnick about what investors should know when valuing illiquid assets. The interview was edited for clarity and conciseness.
CIO: How should institutional asset owners be valuing their illiquid investments, particularly private equity and venture capital portfolios?
BROWN: It’s a tricky question because, unlike public markets, you just don’t observe the prices.
You could engineer it as part of a broader equity portfolio. You don’t know what the kind of true transactable value is for private fund stakes, and this can create problems in terms of how allocations are measured in terms of how new commitments are made. But there’s not a real obvious, easy solution to the problem.
Some people try to make ongoing estimates of what the [general partner]-reported [net asset values] will be. Instead of doing that quarterly with a lag, they try to do that monthly ,and in some cases, even weekly or daily.
That’s definitely a step in the right direction, but it still has some problems, because we know that the GP-reported NAVs are biased. They’re not necessarily biased up or down. Systematically, they’re not always too high or always too low, but they’re stale and they lag. So when the market goes down a bunch, the NAVs tend to not go down a bunch. When the market goes up a bunch, the NAVs tend to go up a bunch.
So in that sense, there’s some facet of that that is attractive to institutional investors because it makes the portfolios look less volatile.
I think the real reason people like private equity is it earns 3% more than public equity—or has done that historically. But the volatility laundering could be part of it as well.
People have known that for a long time– it hasn’t been as much of a front-burner issue.
But now that you’re seeing evergreen funds and increases in secondary market transactions and continuation vehicles, all kinds of things are relying on a need for more accurate and timely pricing. It’s turned into a front-burner issue for a lot of investors.
CIO: Does the expansion of the secondary market assist in pricing these investments or is everything still so bespoke that it’s hard to draw conclusions from prices in the secondary?
BROWN: I think secondary-market transactions are usually informative. The exception would be when there’s a fire sale, when there’s a time of market disruption like we saw during the global financial crisis and maybe a little bit around COVID.
It’s hard to know because you don’t see the data. If you’re privy to that that data or you know prices and secondary market then, yeah, that could be quite useful, but those are not widely available data.
For example, we [at Kenan-Flagler] don’t have any data on secondary market transactions, but I think, in theory, if there was a way to structure something that had some transparency around secondary market transactions, it would be hugely informative.
There’s been some talk of setting up an exchange or tokenizing part of private equity funds, but it hasn’t happened yet.
CIO: How can sophisticated institutional investors be confident that they are paying the right price?
BROWN: I think for large institutional investors, the biggest challenge is probably selling, not buying. They’re more likely to be a seller in the secondary market.
The [valuation] challenge for most institutions is they’re going to have to do it themselves or hire someone to do it. And because the information set is pretty limited, there’s not going to be a high degree of confidence, even with the best models, because it ultimately will be model-based prices.
You’re just never going to see transactions in the underlying portfolio companies that would let you roll up, from the way you would a mutual fund or something, what valuations are. But you can use model-based approaches, and we have a reasonably good model.
[With that] you could say, for a large diversified portfolio, with some degree of confidence, what a fair-market value would be. That’s some of the research that we’ve been doing to try to have a statistical model that gives you sort of an average, unbiased estimate of what fair value would be. But it’s still a statistical estimate.
It’s not people going in and looking at the company and doing a fundamental analysis of the cash flows and all that sort of stuff. You just can’t do that on a daily basis for, you know, 10,000 portfolio companies. It’s just not feasible.
CIO: Can you explain a little bit more about the idea of nowcasting—the concept that you’ve developed—and how it works?
BROWN: So the basic idea behind nowcasting is that there is some true value for funds. You just can’t observe it. So we use a statistical model and the information at our disposal to try to infer what that unobserved fair value is.
What are things that we know? Well, we know the historical sequence of net asset values. They’re infrequent and they’re stale, but they’re still good information.
We know the types of assets that are in the portfolio, so we would know the industries of the companies, we know where they were located. So [we] can essentially create a comparable public asset. [We] also know the cash flows in and out of the portfolio.
So those are all pieces of information that can sort of be mixed together in a statistical model to come up with what’s an unbiased estimate of fair value. And it’s going to have properties that are much more desirable than GP-reported NAVs; because it’s going to act more like a market price because it’s essentially sort of keying off what that comparable public asset is doing.
So, imagine you’re looking at a private equity fund that has 10 holdings. If you were to match the industry and geography of those with similar public companies or industry portfolios, weight them the same way; apply the right beta to them, then you can get pretty close, at least on average, to what a fair price would be.
We’ve done large historical analyses to demonstrate that the prices that we get, those fair-value prices that we get from the nowcasting model, are better predictors of what future returns will be then the GP-reported NAVs.
CIO: How does the nowcasting model incorporate the work of the manager?
BROWN: Let’s say we’re going to evaluate a mutual fund. You would take a benchmark. Say it’s a large-cap U.S. fund, you might use the S&P 500 as the benchmark and you’d run a regression. You’d figure out what the beta was of that portfolio, and then once you have the beta, you can figure out what the alpha is, and you know what the value-add is from the manager.
When we do nowcasting, it’s the same idea. It’s just a much more complicated model because we don’t have daily prices, but we’re going to estimate a beta and alpha.
That alpha would be an estimate of what the manager value-add is. It’s another parameter in the model. It’s not derived from first principles and seeing [that] in this company they increase revenue, and in this company they have expanded margins and cut costs, and those kinds of things. On average, over time, you know what the value creation is from that.
Conceptually, it’s sort of the same toolbox that we use in public markets. It’s just the data inputs and the actual model are very different.
CIO: What are the basic building blocks of what institutional investors need to know in order to accurately keep track of their portfolio?
BROWN: It’s a big data exercise for most investors. The data comes in, it’s not in sort of a standardized machine readable from, the way that public market data does.
You’ve got to keep track of all these different, random reports that come in. There’s a significant industry around providing that as a service now. For most investors, outsourcing that makes a lot of sense. And, essentially [it] provides timely and accurate information is as you could possibly get. In terms of just trying to understand what you own, you’re going to outsource that.
In terms of how you use that information, or how you decide to make investments, there is a pretty established consulting practice. The empirical evidence on consultants is that it’s mixed. Some of them seem to not add much value. There’s been some studies that sort of suggest that some of the large institutional consultants are essentially creating portfolios that match the benchmarks, in some sense. So they’re giving you sort of benchmark exposure?
More specialized consultants seem to be able to add some value. They’re going to be able to, also, provide quality due diligence evaluation to minimize operational risk around private equity funds. But what they’re not going do, typically, is provide a lot of guidance on smaller and younger funds. And there’s some evidence to suggest that the best opportunities are in … smaller funds and newer funds.
CIO: So are those investors that are accessing larger funds, where they can write larger tickets, benefiting from being in private markets sufficiently to justify it?
BROWN: Yeah, on average, the larger funds still have outperformance. [But] in fact, the median large fund does as well as the as the median small fund.
It’s at dispersion where it really matters. Because there’s more positive skewness in the small funds, the average performance is higher. Because you’re never going to see some mega-fund do a 10X deal. But those happen all the time with smaller funds. But you’re also going to have a lot of zeros.
So the trick is … finding those smaller funds that have the skill to generate some really outsized performance in parts of their portfolio, and that skewness is where the skill comes in. Just throwing darts at small funds versus big funds, the performance expectation is the same.
But if you have skill, then that skill is going to pay off more in the kind of smaller-fund space, because you’ll be able to identify those funds that have a chance of generating really outsized returns. And that … skewness, that right-tail type of performance, can be beneficial.
CIO: What do you see as the next frontier for private assets?
BROWN: I think for the most part, the institutional market is at or near equilibrium. In terms of allocations, I don’t think you’re going to see the kind of growth in asset allocation towards privates that we’ve seen over the last 20 years, and the data reflects that different types of institutions have kind of started to level off in terms of their allocations. For endowments and foundations, that’s leveling off at a very high number, the majority of assets being private, illiquid. For pension plans, it’s 20% or 25% or something like that, depending on which country and segment you look at. So I don’t know, at least in developed economies, that there’s going to be a huge increase in asset allocation. There’ll still be growth in assets, just because portfolios grow over time. But the share of the assets probably isn’t going to change much.
The new frontier is for sure the wealth channel. More kind of retail democratization … retailization maybe a more accurate phrase. There is such a huge potential there, [and] there are very small allocations. It’s a huge pool of capital. But then the question is: What’s the packaging for that? And that gets right back to this question of liquidity and valuation.
I really worry about the valuation side of things, just because it is so hard to get a handle on proper valuations. And I worry about the private markets industry not having the history in retail products to understand how important valuations are and proper valuations are. … We’ll figure it out, though.
Tags: Alternatives, Asset Allocation, Greg Brown, illiquid assets
