Notes – Public to Private Equity in the United States: A Long-Term Look
By Michael J. Mauboussin and Dan Callahan, CFA
August 4, 2020 Consilient Observor these notes are taken from.
P. 17
the mix of tangible and intangible investments has changed over the last 40 years. In the late 1970s tangible investments were nearly double those of intangible investments. Today, intangible investments are one-and-a-half times larger than tangible investments.
P. 18
The shift from tangible to intangible assets has had a meaningful effect on the mix between public and private companies. That many young companies have less capital intensity means they don’t need to go public to raise capital…
the economics of information goods, combined with the concentration of traditional industries and the outsourcing of low-value-added activities, means that a handful of leading companies earn much higher economic rents than their competitors and businesses of the past.
P. 47
To begin, there are now numerous examples of companies that have not lived up to their high valuations. These include Theranos (which peaked at $9 billion and later dissolved) and WeWork (which went from $47 billion to $8 billion in 2019). Raising a substantial amount of capital implying a high valuation does not by itself confer success.
Price discovery is stunted in private markets, as only optimists invest and there is no mechanism for pessimists to express their view. The sunlight of an IPO can be the best of disinfectants from overvaluation and can improve productivity.139 From 2011 through 2019, about one-third of the companies that went public had a valuation below that implied by the final round of private financing.140
P. 48
Academics who studied unicorn valuations found eight share classes per company on average.
These professors analyzed the financial terms from legal filings and found that reported post-money valuations for unicorns are roughly 50 percent above fair value on average, and for about 10 percent of their sample the valuation was double fair value. Nearly one-half of the 135 companies in their sample lost unicorn status after they made all of the appropriate adjustments.142
P. 54
In most cases, expected alpha declines as AUM grows. This makes sense because as AUM grows the opportunity set shrinks. In theory, a fund that is managed with skill will expand its AUM to the point that expected alpha approaches zero. Because investors anticipate that buyout and venture capital funds will earn returns in excess of public markets, it makes sense to enhance the concept of capacity with a threshold of positive alpha.162 In other words, capacity equals how big a fund can get while still generating expected alpha of one or two percentage points per year.
P. 55
In buyouts, the most common measure of valuation is the EV/EBITDA multiple.164 While at record levels, the headline multiple needs to be considered in the context of interest rates…
One important finding is that buyout firms tend to generate worse returns in funds that drift from their original style.167
P. 56
Combine high dispersion of returns with a lack of access and it is easy to see why many investors in private equity may be too optimistic about the returns they will earn…
The timing of general partner compensation also appears to be a relevant factor in determining returns for venture capital funds. Returns for limited partners are higher before and after fees when the agreement is to pay general partners on each deal rather than deferring carried interest until the fund has reached a benchmark return. As with most corners of the investment world, there will be pressure on fees for many buyout and venture capital firms.173 Similar to active managers of public equities, firms that demonstrate skill will be able to charge above average fees. But investors will likely challenge the lower tier of the industry to lower fees.
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