The soundness of making allocations to private equity (PE) is being called into question by managers’ performance converging, according to co-head of asset allocation at GMO, Ben Inker.
In a letter to the firm’s investment committee, Inker explained he has started to notice something ‘a little jarring’ that may not be as obvious to investment committee members who only experience the performance of one or two institutions.
He said that while it is well known private equity has failed to keep up with the public markets over the last several years, he is also hearing from a number of institutions that the performance of their particular PE portfolio is no longer beating the Preqin, Cambridge Associates, or other composite, despite having done so earlier.
“There is usually an excuse that feels specific to the institution in question: ‘we focused too much on co- investment opportunities and failed to keep a high enough bar on our expectations for the actual fund performance’. or ‘we were too slow to react to our GPs’ loss of focus and mission creep’,” Inker said.
“The implication of those explanations is that fixing a particular problem they diagnose will lead to better relative performance in the future.
“But there is another explanation for this phenomenon that is less fixable and feels awfully plausible to me: if the persistence of performance for PE managers has gone away, or even significantly deteriorated, the performance difference between the best institutional PE portfolios and the mean is doomed to collapse to low levels.
“The case for private equity, rather than resting on some vague ‘illiquidity premium’, was all about finding extraordinary managers,” Inker noted.
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He added for private equity allocations predicated on a belief in the ability to find and secure these managers, an absence of performance differentiation would call into question the rationale for the allocation in the first place.
Inker said the first question any investment committee should ask when discussing an allocation to private equity or any other private asset is: what makes us confident we can find these extraordinary managers and get meaningful allocations to their funds?
“If the committee can’t credibly answer that question, it makes little sense for them to try to replicate the asset allocation of institutions that can.
“But even for institutions that have reason to claim such a selection ability, private equity fund performance really needs to be significantly persistent for the game to work. And it is far from clear that such persistence exists.
“At the end of the day, the role of the investment committee is to help the investment staff do a better job managing the portfolio,” he continued.
“That should not be about second-guessing individual manager decisions, but pushing the investment staff to think critically about what they do and why it is absolutely in the committee’s wheelhouse.
“Private equity programs are not meant to run on autopilot; there are critical questions to answer and, for many institutions, disappointing results to grapple with.”
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