Listed private equity: A contradiction in terms?

Barbarians at the gate

Once famed for swashbuckling acquisitions and larger-than-life dealmakers, private equity has since matured into a core asset class for institutional investors. The approach, which involves owning stakes in private companies, has become a common feature of high-growth portfolios (such as US university endowments) and has produced stellar returns for the past decade.

However, for many multi-asset investors, complicated fund structures and the need to lock-up cash for years at a time has made the asset class difficult to access.

To get around these issues, many investors (us included) use listed private equity to gain exposure to the private equity sector in a more liquid form. In practice, this involves owning the listed equities of private equity managers, such as Blackstone* or KKR*, or listed closed-ended companies such as Pantheon International* – entities that are expected to have a fundamental relationship to the private equity asset class over the long term.

However, the benefits of listed private equity are often called into question. After all, how can something with ‘private’ in the name be available to investors in a daily-traded form on a public market? Isn’t this a contradiction in terms?

Fundamental connections

A common argument is that listed private equity managers are no different from any other listed companies and simply offer market exposure. While this may be true over short time horizons, we see strong fundamental reasons why listed private equity returns could reflect the health of the unlisted private equity sector over the long term.

First, there is a fundamental linkage between the success of the private equity sector and the cashflow accruing to listed private equity managers. The more assets allocated to unlisted funds, the greater the management fee revenue earned by listed companies. This may even positively counteract any performance headwinds arising from crowding in direct private equity funds.

While this implies a general positive tailwind from the growth of private equity assets under management, what about private equity performance? Helpfully, this is also reflected in listed company cashflows. A material proportion of the equity value of listed private equity firms relates to performance-related fee income from their underlying funds. If the funds perform well, the manager receives more cashflow and their stock market valuation is likely to increase. This can be compounded by managers investing their own balance sheet in their funds.

The net effect of these fundamental linkages is that there is a direct relationship between earnings and book value of listed private equity companies and the performance of their funds. This underlines their use as an unlisted proxy.

Out of sync

A second question is that even if there are plausible reasons why listed private equity should be an effective proxy for private market exposure, why is this diversifying for a multi-asset portfolio? The answer is twofold.

Firstly, the valuation of private companies, and by extension, the performance of private equity funds, is only partially related to public equity markets. The appraisal-based valuation methods used in the private equity industry are less responsive to short-term market movements, tending to provide less upside potential in equity bull markets, but less potential downside risk in periods of weakness. This can provide a degree of stability to private equity asset values, as evidenced by the relatively muted impacts of equity drawdowns in 2020 and 2022.

Secondly, unlike traditional asset managers, a substantial proportion of the management fees earned by private equity companies are based on a fund’s initial commitment value, not the mark-to-market asset value. As a result, there is high visibility of fees for private equity funds for several years after they are launched and minimal market impact.

The combination of these two factors, gives a stability and idiosyncratic dimension to listed private equity cashflows. As a result, investors can potentially earn a high expected return with the potential for diversification over medium-term time horizons.

Takeaways

Listed private equity is not a gimmick or a contradiction in terms. We believe there are fundamental reasons why the long-term prospects of the underlying companies could be closely related to those of the private equity industry and private fund performance. We also believe that the asset class can also provide a useful portfolio tool for adding diversifying growth exposure to well-constructed multi-asset portfolio.

* For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] It should be noted that diversification is no guarantee against a loss in a declining market.