Gavin Baker+ Your Authors @GavinSBaker Husband, Becky Painter. CIO, Atreides Management. Former PM, Fidelity OTC fund. investorfieldguide.com/baker/ No investment advice, views all my own. Mar. 22, 2019 3 min read + Your Authors

1) A valuation premium for illiquid assets relative to liquid assets is the logical consequence of defining risk *entirely* as volatility. The “liquidity premium” is now the “illiquidity premium.” 🧐

2) Making private and venture investments improves the Sharpe, Sortino and Upside/Downside capture ratios of any public equity fund. Putting series A investments in a large cap growth fund focused on public equities would *lower* its measured risk. 🤔

3) The preference of some LPs for PE, most recently expressed by Calpers as “We need more private equity and we need it now” is also partially a function of equating risk with vol. PE is a levered bet on mid cap public equity. Accurate, frequent marks (vol) would hurt the model

4) Good PE firms add value by selecting the right investments and timing entries and exits well from a mkt perspective (one reason I don’t like buying from them). And they do generally add value to portfolio companies.

5) But much of the PE magic comes from having LT capital & a long holding period on good businesses that are levered (and effectively cross collateralized as PE funds help prevent individual portfolio co’s from going bankrupt) w/o the stress of frequent, accurate marks

6) And many LPs have realized that not only do many of their fund managers make bad decisions in response to volatility, but that they (the LPs) also make bad decision in response to vol with their public equity managers. Easier - and rational - to own Private Equity.

7) It is supremely difficult for anyone – whether they are a public equity PM or an LP - to rationally respond to volatility. Sidenote – was interesting to see FinTwit turn into group therapy advocating rational behavior in Dec. 2018 (seemed to work – lots of people bought).

8) Fired managers generally outperform hired managers, etc. I have friends who programmatically buy the top 10 of any fund manager who is fired. When the LPs, the mgmt of a fund company or the PM who shuts down can’t take the pain anymore; it is generally a good time to buy.

9) Some LPs explicitly indicate that they look to allocate capital to – rather than fire – their public equity managers who are underperforming. But that seems to be the exception rather than the rule (no complaints – that is the game I/we have chosen to play & I love it).

10) Easier to own Private Equity where it is more difficult for everyone involved to make bad decisions in response to volatility. Although where there is a will, there is a way and can always sell one’s holdings in a Private Equity fund at a discount on the secondary market.

11) So the continuous shift towards PE is eminently logical in the context of risk being defined as volatility & the difficulty of responding rationally to vol. I don't think it will stop. And will be interesting to see how long the “illiquidity valuation premium” persists.

12) To be fair, later stage venture/growth investments are made in the form of preferred stock which do change the risk/reward calculation relative to common stock. In some ways, they are actually lower risk and therefore merit higher valuations.

13) Liquidity preferences are real. And work to the disadvantage of entrepreneurs, which is one reason I’ve told many founders that high valuations are hazardous to their financial health. “Unicorn” status can be very painful if numbers are missed (& they often are).

14) Finally, it is also interesting that previous instances of an illiquidity premium happened in the mid 1980s and 2007/2008…not that I’m bearish, but does make one think. And in a big down market, people do want liquidity…


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