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Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about listed private equity companies with Alan Duffy, head of systematic investment strategies with Keyridge Asset Management. We talked about liquidity and managing NAV discounts and premia. And we started by asking where we are in the private equity cycle.

Alan Duffy (AD): What I’d say is we’re definitely in a more mature phase of the private equity cycle. That era of very cheap money has gone. That’s been replaced with higher interest rates, and more selective financing. And that slowed down some traditional buyout models. IPOs, for example, which would be traditional exits of private equity companies, they’re less prevalent at the moment. What that does do, then, is it gives private equity companies more time with the firms they own in order to do what they’re supposed to do, which is create operational efficiencies, improve the capital structure, and just really get into the weeds of the companies they own. What we can say is that despite where we are on the cycle, private equity is still a core allocation for large institutions. And that’s expected to keep growing structurally. In a more mature part of the cycle you have a greater dispersion of outcomes You’re going to see a bigger dispersion of who’s able to harness this part of the cycle and who struggles. And that’s why active management in this sector is so important.

The allure of listed private equities

AD: Why would anyone want to consider investing in listed private equities versus directly in private markets? I’d give you three reasons. Access. If we think of allocating or committing capital to a private equity fund, you generally face a number of frictions. You will have large ticket sizes, long lock ups, capital calls and operational difficulties. And that is suitable for some investors, but not all. What you have here is an ability to participate in the economics of private markets but, instead, you’ve got this listed transparent vehicle, which just creates that access which previously wasn’t there for a lot of people. Second of all, diversification. You get to own a diversified portfolio of funds that run the private equity industry globally. It’s not that you’re allocating to one fund and one vintage. You’re investing in these top-tier funds and companies that run the entire ecosystem of private assets. And then, the final thing is flexibility. You can buy and sell through a very familiar mutual fund structure with daily pricing, standard dealing, all the good stuff that people are used to when investing in equities, for example. It’s that combination of private market exposure, public market liquidity, and operational simplicity that’s the key attraction to a strategy like this.

The structural characteristics

AD: We think that public market liquidity is a genuine advantage, but it does come with some trade-offs. First of all — and most clearly — there’s mark-to-market volatility. That means that there’s more day-to-day price fluctuations. If we think of how a traditional private equity fund might value their assets, it may be quarterly or semi-annually. Intra those periods, the price of the assets or the value of the assets doesn’t move, whereas if you’re daily trading, it moves around. We believe that as those prices of the listed private equity companies move around, that it continually provides opportunities for us as active managers to cycle into companies or firms that we believe are well positioned or have been underpriced by the market for some reason. It increases our opportunity set to invest.

The risk of more volatility.

AD: Private equity is known for return smoothing. Listing will reintroduce public market volatility. The underlying economic risk can be more visible and more tradable within these listed private equity companies. For us, this means there’s an opportunity to really understand what the market thinks of the value of the private equity company at this point in time. In terms of whether this introduces volatility that investors may not expect, the key is around communication. We treat listed private equity as an equity allocation with private market drivers. We wouldn’t see this as a replacement for a full commitment to a private equity fund that’s valued twice a year. You’ve got to view this as an equity allocation with private market drivers.

On liquidity

AD: When I think about liquidity in private equity companies, I think it’s important to just look at how they run their fund. A private equity company will take allocations from investors, they will accrue all of that up, and then they will deploy that into unlisted assets. They’ll then take many years to improve that underlying business, either through improving the capital structure, management, operational efficiencies, etc., and then they will exit the company and hopefully realize a gain. And that cycle can be seven to 10 years from start to finish. The problem for that business model comes about when — or if — investors want to exit that fund before the private equity company has exited its company holdings. So, it hasn’t had the time, effectively, to bring about the operational efficiencies that it wanted to. The net result of that is that they potentially could be a forced seller, which means they exit the assets at an unfavourable price. And this is kind of a liquidity mismatch between investors and the fund and the assets that they hold. The difference between this and a listed private equity company is that with listed private equity, you have a claim on the cash flows of a going concern, asset management or investment business. You don’t have a direct redemption right on the underlying funds. What that means in practice is, if an investor in listed private equity wants to remove their investment or sell out of it, they do it through the listed equity market, rather than through redemptions from the private market vehicles themselves. Whilst the underlying assets remain illiquid, the listed structure allows investors to adjust their exposure directly and daily. It deals with the liquidity mismatch by offering daily liquidity, but you don’t have a direct claim on the underlying assets.

Evolving investment platforms

AD: There’s been a definite evolution of listed private equity from traditional buyout firms into much broader private market platforms. And that includes things like private credit. But it also includes things such as infrastructure, real estate, and private equity more broadly. For a client, if they’re invested in one of these platforms, you’re gaining exposure across multiple different private asset classes. In a portfolio term, we get a sort of an all-weather exposure across the private assets ecosystem. For example, if buyouts are struggling in one part of the cycle, infrastructure may be very good. And this just gives ballast within the portfolio. We believe that the optimal way to run these private assets businesses is to have diversification across multiple different private assets, simply because of the business stability and the opportunity that it brings.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to Alan Duffy of Keyridge Asset Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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