Why does private equity get to play make-believe with prices? | Hacker News Reader

Why does private equity get to play make-believe with prices?

institutionalinvestor.com

89 pointsjpn33 comments

> It’s hard to avoid the idea that my confusion [...] is resolved by noting a principal–agent problem where the PE managers get paid a ton so intermediaries can then report unrealistically rosy assumptions and unrealistically calm returns. The chickens come home to roost only if long-term returns no longer beat public markets [...] But both parties involved, principal and agent, may be assuming that in ten-plus years that’ll be someone else’s problem.

So... because "rules are for the little people, and I've got my commission, so fuck you that's why"?

He who has the gold makes the rules!

Backers of PE funds are not "the little people".

As it says elsewhere "it takes two to tango" in this game.

Yes but if one of the two lies, successfully, to the other player or players, is that even really still the Tango? Partner dancing involves trust in your partner - that you're not going to dip them and then drop them to the floor when the opportunity to make a bit of cash arises, to abuse the metaphor.

Isn’t there also a component that PE is incentivized to work for existing investors more than new investors. If they mark down an asset in a bear market and a new investor puts money in they will potentially dilute future profits for existing investors by possibly letting them in at a lower price. If the market recovers, the new investor sees all those gains. If the asset isn’t marked down, those gains are shared with existing investors (b/c the new investor had to pay above market).

The majority of private equity (incl. VC funds) funds are close-ended by definition [1].

Once the fundraising completes for a fund, no “new” money is allowed into the fund. New investors can invest with a PE firms in 2 ways: invest in a new fund, or purchase shares of an existing fund on the small secondaries market [2].

So no, in most cases PE portfolio managers are not going to track “new” vs “existing” money within a fund.

There are exceptions, ie there are PE asset classes that are open-ended (ie. The infamous Blackstone REIT [3]). Open ended funds are more common for public equity hedge funds.

[1] https://www.investor.gov/introduction-investing/investing-ba...

[2] https://www.institutionalinvestor.com/article/b1zspcywbpn2h7...

[3] https://on.ft.com/3Zc7Wku

If you had $10 billion in cash and had to allocate it, how much would you put in private equity? What is your incentive?

I see the appeal to private equity as a walled garden. Only elites get to invest in startups, and keeping the masses out keeps prices down (supply and demand). Depending on your outlook, you could say public markets are a bit of a ponzi scheme too. So dumping your private equity out onto the market with an exit lets you get in at the beginning of the scheme. Another big win.

The author says there are too many people in PE and the premiums are too high, but relative to public equity, I am really not sure. The author also mentions how bad the liquidity is, and that should also move prices down even further. So as far as economic opportunity it still seems like a good deal.

That being said, if I actually had $10 billion, I still don't think I would put more than 5% in because of how often startups fail and how bad the liquidity is.

Private equity generally buys EBITDa positive businesses from each other and founders. Highly unlikely PE marks many investments to 0, rather just less than purchase price.

Venture capital is only a small part of PE.

"Only elites get to invest in startups"

Most VC firms are backed by institutional money, like pension funds. This is money owned by every Tom, Dick and Harry. Not elites. It's managed by purported experts, but the money and the profits will go to average joe.

This is empirically not true when you look at the data on who owns financial assets in America. The "average person" owns essentially no financial assets. The median person especially owns approaching zero financial assets. The top 10% and then again the top 1% own a drastically disproportionate share.

The one exception is Pensions and 401ks but this does not even come close to skewing the math in terms of "normal people" owning a significant portion of financial assets. All US pensions and 401ks combined have a total value of something like 10T. And that's before the fact that a huge value of the 401ks are still held by the top %s.

And that's aside from the fact that a lot of US pensions are in deep deep shit right now and may never pay out even close to face value on their obligations as denominated in 2023 dollars.

https://fred.stlouisfed.org/series/BOGZ1FL594090005Q

25 trill of pension assets in the US. It's a lot. It's money for teachers, police, other government workers, all kinds of regular folks. Many of them don't know where the money goes and it's not legally theirs, but it's legally owned by an entity which has obligations to them, so it's almost as good as theirs.

So some investors believe in whatever PE tells them companies are valued at. The market is not out of the equation here because PE firms are competing with other forms of investment for investors money. If they are much better at valuation than public markets - good for them (and for investors). That's how they get to play make-believe.

When private companies eventually are sold via IPO or privately, all rosy estimates meet the harsh reality of what somebody is willing to pay and all overly rosy estimates are exposed. The reputation of the PE firm will reflect investors ROI (and they are usually pretty transparent about this).

Alternatively, some sort of profit sharing can yield long term profits from just holing private shares.

Do you really still believe that? What if you have friends that control significant portions of the investment in the markets and you can get "bailed" out with those relations?

I have no doubt that some people find it easier to get money than others. But there's a lot of high-profile failures, most recently WeWork, which pretty clearly show that having lots of friends in powerful financial institutions isn't sufficient to get the public market valuation your investors want.

Wework and Uber are still chugging along. If all deals flow through a few hands, then the price can quickly become “whatever we say it is”. Savers must invest.

But in public markets all deals don't flow through a few hands. That's why Wework could not, in fact, make the price become "whatever we say it is" - they're currently down 85% from IPO and 98% from the valuation they and their bankers originally pitched. (Uber's not quite so far down from their IPO, which I assume from your comment you'd argue is due to some kind of trickery, but is it impossible that there's just a lot of people out there who honestly think Uber has a good business?)

My understanding of the wework debaucle is that it ultimately came down to the s-1 filing. The s-1 was so poorly reviewed that it raised questions with the LPs and others that it blocked the IPO.

On the other hand, Uber still loses >1.2 billion per quarter on a 13 year old business. It’s unclear if this trajectory will ever change - but their stock goes up when they lose more money.

There is no guarantee that the markets choose to value profits in the future… which begs many questions.

The primary purpose of an S-1 filing is for investors to read to the prospectus and decide whether they'd like to invest. When a bunch of investors read it and say "no I would not", that's not a lucky catch, it's the system working as designed.

I tend to agree that it's unclear if Uber's trajectory will ever change, which is why their stock is down 37% from IPO and over 50% from its all time high. But it's not unheard of for a company to be unprofitable for a long time until it starts pulling in billions, so it's not surprising that some people honestly believe Uber will pull it off.

aye - however I'd imagine if Jamie Dimon wrote the S-1 it would have gone through at the original valuation. The core claim of the investors was ultimately that WeWork would be the primary demand aggregator for commercial real estate - giving it extreme leverage over landlords and tenants. The second component for the claim was that WeWork would make commercial real estate business's look better on paper if they could have wework as a tenant, particularly if WeWork continued to take losses for multiple years. WeWork's business model was also somewhat unique in it's ability to handle higher interest rates in the future thanks to it's short-term leases.

I can't imagine that Jamie Dimon and others couldn't have written the S-1 convincingly in 2019 when interest rates approximated 0. The problem was that the S-1 was not written for finance professionals, and made an investment in the vision appear foolish. On the other hand... Uber's was, and Uber was able to successfully IPO despite similarly dire financials.

If you have friends that give you billions of dollars then that's fine, it's their money. If they do it with the intent of manipulating stock prices then it's obviously illegal. This isn't market inefficiency in either case.

Suggesting that someone is naive because they don't believe in a grand conspiracy is a bit much.

The finance industry is full of smart hard working people trying to cut each others throats. The idea they are all conspiring together isn't realistic to folks who've spent time in it.

TL;DR:

Because investors like pension funds and college endowments do not want the write-offs.

It's in their short-term interest to pretend the make-believe valuations are real. The numbers look prettier that way.

They keep their fingers crossed that everything will turn out OK in the end.

This feels like a bad take unless one has some data on how often it turns out OK. If it frequently does, the implications of the first bit seem off

Whether the declines in valuation turn out to be permanent or temporary doesn't matter, institutional investors are incentivized not to recognize them in the short run.

They want held to maturity accounting treatment on all the things.

It's not that. It really is mark-to-make-believe: Institutional investors want PE managers to ignore declines in public market valuation multiples because if the managers were to value their PE investments at current multiples, the investors would have to write off the value of their PE holdings.

For example, say a PE fund invested in a new EV company a bit over a year ago, at a valuation 10x trailing revenues, and then the fund doubled the valuation of that investment to 20x trailing revenues because Tesla (TSLA) was trading at 20x. All investors happily went along because they could show a +100% gain on this investment by the fund. Now, however, TSLA is trading at 4x trailing revenues, but the fund manager contends that it should ignore a capricious stock market and treat the investment in the EV company instead as if it were still worth 20x. All investors in the fund are happy to go along with that too, because otherwise they would have to recognize and report a loss of ~80% on the fund's EV investment.

But are those numbers realistic and representative? How much higher will they be marked, and more importantly, how well correlated are the “make believe” prices to eventual selling prices

Ponzi schemes all work until they become insolvent.

Not at all a bad take. The PE model has only existed during the ~40 year period that were an extreme outlier in terms of bond performance, liquidity, and equity return averages. They've never had to suffer a tail event that wasn't papered over with cheap money, even though we know historically that the papering over of business cycles is not a game that can last indefinitely.

Demanding "data" from other people without explaining why that person has the burden of proof to produce data for something they have already explained while the requester has simultaneously also provided no data on anything is one of the laziest and lowest value takes that frequently gets repeated on here.

My claim is that if you don’t have data showing that PE doesn’t tend to deliver on its valuations then it’s probably not justified to attack them for not updating their valuations. Adjusting for market conditions may not be a good model.

I don’t know this to be true, but I feel like I’m claiming the null hypothesis here. That it’s not determinable.

PE held companies are not liquid and undergo significant changes.

PE shops get paid based on their assets under management (AUM).

If they write down their investments, their AUM drops, and with that the fees they charge.

Their fee is based on committed capital not marked up AUM

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