Private Equity and Public Markets Are Not So Different After All
Traditionally, the idea of private equity funding was to achieve mid-to long-term financial returns. The mindset was to outperform the public markets by adding value to businesses through operational change. In this era, GPs relied on business acumen to identify companies that would massively benefit from an infusion of cash, a change in managerial fundamentals, or modifications to its product or service offerings. Limited partners depended solely on their GPs’ research and expertise to drive value and manage exits. LPs didn’t expect returns until long after the initial transitional period and waited for their GPs’ labor to appreciate fully.
Public markets operate differently. Stock prices fluctuate based on a company’s quarterly reports and intermittent releases. When a company liquidates a product line, it’s challenging to ascertain whether they’re trimming down to sure up their successes to gain traction with the risk-averse or if they’re slowing growth to free up equity to appeal to short-term investors. CEOs and executives take a short-term view to instill confidence in their shareholders. They use methods such as share buybacks and dividend distributions to increase or stabilize share values.
In the short term market, management bases its decisions on public reaction to the here and now, rather than looking to produce value that will increase shareholders’ long-term gains. Public market investors share this view in kind. They place their funds in investments they believe will produce results rather quickly. They typically base success and failure on stock prices and company news. Some argue that growth-based investors are the best of the public and private world as they have some tolerance for negative market swings; however, the average investor has little to zero appetite for downward slides or stable prices.
For better or worse, the private equity asset class was traditionally a longer-term play, while public markets were geared towards the short to mid-term, from both the investor’s and management’s standpoint. High-level executive decisions were clearly reflective of these very distinct mindsets. While public market investing remains the same, changes in the buyout market have narrowed the gap between public and private market investing. The downsides and dangers that come with short-termism are creeping into private equity.
Some limited partners have lost patience and are over-weighting quarterly and year-end results as benchmarks for success. Instead of transitioning companies and positioning them for long-term growth, managing sponsors are obliging by using short-term tactics similar in style to public market management to show value or increase it temporarily. Does this sound familiar? I don’t think this is very healthy.
Rather than selling companies at the very point of inflection to artificially or prematurely create liquidity, LPs should encourage their managers to fulfill assets’ true value. While it’s nice as an investor to feel secure and cash out with higher returns than the public markets, pivoting to this as an overall strategy can create undeserved alpha. Patience is a virtue. A company’s holding period should be in the 10-year range to reap the full benefits of the operational intensity associated with investing in buyouts. Selling early typically means leaving value on the table and possibly dropping a mess for the new owners to clean up.
Traditional private equity investing entails fundamental changes to a company’s vision, past practices, and operational model, which all takes time. Sure, mimicking the public market may provide short-term liquidity – but as with anything artificial, true investor eyes will begin to determine who is faking returns and who is making them. At the same time, going back to the basic fundamentals underpinning the formation of private capital – will also yield better results.