By John L. Bowman, CFA
This editorial first appeared on Sept. 18 in Crain's Pensions & Investments online edition.
It’s open season on private equity in the Democratic presidential debates. Senators Elizabeth Warren and Bernie Sanders and others have made attacking “Wall Street” a major plank in their campaign platforms. There’s nothing new about inventing a common enemy to ignite a movement. But what is different this time is the level of demonization and the proscribed penalties on offer.
Reasonable people can disagree on the tax treatment of carried interest, but much of the campaign bluster and its underlying insistence on the evil of private capital – represent a fundamental misunderstanding of how markets work, and its implementation would do huge damage to the efficient allocation of capital across the U.S. economy and beyond.
Needless to say, perhaps the greatest of ironies is that many of the underlying investors/beneficiaries in private market allocations are the very teachers, police officers, firefighters and hard-working public employees that this fear-mongering claims to protect. But I digress.
In making the case against private funds, the primary dialogue has leaned heavily on anecdote, emphasizing worst-case scenarios. There’s no disputing that these examples have “posterized” the worst of excess, but they don’t represent the majority of GPs, funds, asset managers, or the generally positive impact that private capital has had on business formation and economic growth. Regardless of your politics, the plural of anecdote is still not data.
Our organization, the Chartered Alternative Investment Analyst (CAIA) Association, represents savers, beneficiaries, and the general public. As such, we proudly occupy objective middle ground — we’re not trying to win a campaign with dramatic sound bites nor blindly protect a revenue stream or business model for the investment profession at the expense of Main Street. The ultimate goal of the financial markets after all is to efficiently allocate investment capital to the most socially and economically sound opportunities – giving asset owners access to a variety of diversified cash flow opportunities to help them meet investor outcomes. And diversification across the full risk premia spectrum, including private asset classes, is a founding principle of proper fiduciary responsibility.
As such, a more balanced platform is needed and that starts with recognizing the unique benefits of private capital. Most importantly, private investment is generally unmoored from the short-term machinations of public markets allowing managers to avoid the herd mentality and the distracting gyrations of the media news flow. This provides much better alignment of investors and management for long-term value creation as it liberates investors to take advantage of market dislocations, information asymmetry, and out of favor or countercyclical opportunities. And, it facilitates a more natural channeling of long-term pools of capital into impact and ESG projects such as infrastructure, real estate, clean energy, agriculture, and water.
From a business perspective, private funds tend to overwhelmingly focus on start-ups and small- and medium-sized businesses, generally seen as the economy’s engines of creativity, job creation, and middle-class wealth. These companies are often R&D intense, with little in the way of tangible assets, and in significant need for growth capital. They are the mirror image of the traditional, asset heavy organizations listed on public markets. The ability for private markets to more quickly and effectively revitalize stagnant businesses or simply redeploy that capital to entrepreneur’s innovative ideas is a disruptive force that is a critical principle of any competitive and growing economy.
For all these reasons, particularly their alternative and uncorrelated cash flows, private capital asset classes should be a considered a core piece of any long-term diversified portfolio. As such, experts anticipate continued increases in allocations to private and alternative assets. Towers Watson, for example, expects allocations from institutional investors to continue to increase from approximately 14% today to 20% within 10 years.
Room for improvement
This is not to say that there isn’t room for significant improvements in the private markets and industry groups and managers have done themselves a disservice by suggesting that the current model is not rife with abuse and loopholes. We would argue for a standards and reform agenda that includes the following:
- Material equity ownership of GPs in their funds to align interests amongst all investors and stakeholders;
- Better disclosures on costs, standard of care, and ownership structure;
- Avoidance of “pirate” mechanisms, such as irresponsible debt covenants and unnecessary dividend payouts to line owners’ pockets at the long-term expense of portfolio company employees;
- More reasonable and defensible fee levels and carried interest calculations consistent with ILPA’s Principles 3.0;
- Uniform definition and performance reporting of internal rate of return (IRR) in compliance with CFA Institute’s forthcoming 2020 GIPS Standards and;
- The implementation of robust financial literacy and disclosure rules coincident with any liberalization of the eligible investor rule.
Furthermore, rather than artificially attempting to reverse the unprecedented movement of investment capital from the private to public markets in recent years, policymakers should ask themselves why this shift accelerated so aggressively in the first place. A continuation of this trend threatens to leave the large majority of the public and average savers out of participating in what is becoming the heartbeat of capital formation. Even as trillions of dollars have been invested in private funds, public listings have more than halved in the last 20+ years and the public exchanges are increasingly dominated by older and more traditional industries. For the moment, public markets remain much larger than private markets and are the best reflection of democratic and participatory capitalism. But they need serious attention and reform if they are going to continue to play that role.
Public companies face a number of challenges that privately-held companies don’t, including the market obsession with quarterly reporting and peer-to-peer fund rankings that foster short-term emotional volatility; one size fits all regulations like Sarbanes-Oxley and Reg FD that saddle start-ups and growth stage organizations with onerous administrative costs; excessive activist fears and influence; and the difficulty for SME issuers to attract brokerage coverage and investor interest. Where is the outrage from the primary podiums on these shortcomings?
Finally, public companies don’t do themselves any favors either when management feels pressured to focus on “shareholder value maximization” to the exclusion of other stakeholders. The potential social and economic damage of the latter is finally being recognized. CEOs are starting to speak out, as seen most recently when nearly 200 top executives issued a statement through the Business Roundtable seeking to redefine the purpose of the corporation and move it away from shareholder primacy.
There are good economic reasons why capital has migrated to the private markets and demonizing private funds won’t change that. While draconian regulation will only make the allocation of capital more inefficient, responsible reform is needed to protect investors in both the private and public markets. Without balanced and thoughtful private and public reform we may ironically start hearing the opposite complaint in a few years – that smaller investors are missing all the good opportunities because they have insufficient access to the private markets.
John L Bowman, CFA, is senior managing director at the Chartered Alternative Investment Analyst (CAIA) Association.