In the pre-dawn hours, between bleary-eyed bottle feedings, I read one of Jack Bogle’s books.

And as the founder of Vanguard described the rationale for the first index fund, I experienced a eureka moment.

What if we created a publicly listed, passive index fund for private assets in developing countries?

It’s crazy, right?

But let’s consider the following.

First, there is a secular, global trend toward passive investing in publicly traded securities — most managers fail to outperform their benchmarks, and investors are tired of paying fees. See, for example, these charts from a recent BIS study:

Screen Shot 2019-12-13 at 9.26.37 AMScreen-Shot-2019-12-13-at-9.28.57-AM.png

Second, existing publicly traded EM products have failed global investors. As noted in October’s newsletter, the MSCI EM Index has delivered terrible net returns over the last 10 years (3.3% as of 29 Nov 2019). Is it poorly constructed? Maybe. But it’s also important to note that the number of listed companies in EM is not keeping pace with their growing share in global economic activity — listed companies grew by only 17% between 2000-18, while real GDP grew 2.5x.

Third, actively managed EM public equity funds have generally underdelivered over all time periods (see below).

Screen Shot 2019-10-16 at 3.21.14 PM

Finally, EM private equity funds have also generally underdelivered, with a backlog of un-exited companies trapping capital that could be recycled into new funds and deals. Portico’s own research suggests that 56% of the PE firms that raised capital from 2005-09 failed to raise a subsequent fund.

* * *

What if there were an asset manager that could agglomerate a sufficient pool of capital through a publicly listed vehicle (e.g., a super-SPAC) to go out and purchase — in whole or in part — scores of PE-backed companies across EM?

In theory, PE-backed companies would have stronger fundamentals and more capable management teams than the majority of private companies in EM. In addition, they would offer a different sector composition than one sees in the MSCI EM Index — less exposure to commodities, more exposure to consumption.

This asset manager would then effectively sit on top of an index of EM private companies. In principle, this would present investors with the following benefits:

  • Diversification — geographic and sector-diversified portfolio reduces macroeconomic, jurisdiction, and idiosyncratic risks.
  • Unlocking new capital — the purchase of PE-backed companies creates liquidity events for the PE funds, enabling the managers to distribute cash back to asset owners, who may then deploy capital into new funds / assets.
  • Alignment — As a long-term shareholder, the index fund benefits from long-term capital appreciation that doesn’t hinge on an exit. Local entrepreneurs are liberated to pursue genuinely long-term growth initiatives.
  • Lower fees — As an index product, management fees should be lower than actively managed strategies, and transaction / advisory / carried interest fees would be removed.

The asset manager would earn a management fee. But it might also benefit from additional revenue streams and alpha generators, such as licensing the index to ETF providers, or capturing value from an unparalleled dataset on EM private company operations and performance drivers.

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There are loads of questions that this idea raises: Which investors would be interested in this? How do you choose and value the investments? What are the governance rights? How do investors earn returns (dividends but what else)? How would the index fund help scale and create value in the companies? How is sustainability embedded? How do you manage back-office / reporting functions? How do you actually get the underlying data from the companies? Etc., etc.

It’s also based on some key assumptions, including:

  • EM private companies exhibit stronger business fundamentals (e.g., revenues, earnings growth) than their publicly traded counterparts;
  • PE firms do a good job of accessing the highest-quality private companies in EM; and,
  • PE firms would be willing to sell their EM portfolio companies.

With this in mind, Portico conducted a survey last month to test some of these assumptions and triangulate sentiment toward an index fund of EM private companies.

What did we learn?

  1. Respondents perceive that the share of EM private companies exhibiting strong business fundamentals approximates the share of publicly listed companies (~60%).
  2. Only 58% of respondents agreed with the statement “In general, PE firms invest in the highest-quality companies in EM.” 15% of LPs disagreed with it altogether.

    To be fair, the question fails to account for PE’s potential to improve operations, or strategies like distressed that make the question irrelevant.

    Still, this quote from an LP provides food for thought: “Fund managers say that they will invest in the top players in their respective sectors; however, that is not always the case. They may get second- or third-best for a number of reasons (valuation, pressure to invest the capital by the investment period, etc.).”

    As does this one: “Increasingly, fund managers appear to be investing in companies with lower fundamental quality, relying on later rounds and multiple expansion for ‘growth’ — only to find no liquidity at the end.”

  3. Roughly one-third of the fund managers would be willing to sell all of their portfolio companies at NAV. An incremental 55% would be willing to sell them at a premium to NAV. Nobody would be willing to sell at a discount to NAV.
  4. 69% of LPs would not consider investing in an index fund of private companies in EM.
* * *

It was all a bit disappointing and deflating, to be honest.

A sour way to end the year.

And the naïveté on display?

Shameful.

But then … the Head of Data Science at AngelList recently released a report saying:

Our model shows that at the seed stage investors would increase their expected return by broadly indexing into every credible deal …

An index fund of private companies!

Sure, the findings don’t hold at later stages. But what if they do in EM? For a definable segment of the market?

What if the institutional investors we surveyed are the wrong audience for the index fund?

What if the index fund is the way for a larger universe of investors — such as non-accredited / retail investors or smaller institutions — to access private markets opportunities in EM?

What if this is the product that unlocks capital *at scale* for the SDGs?

Shouldn’t we find out?

Please reach out if you’d like to look into this together in 2020.

Until then, happy holidays. Health and happiness to you and yours.

Alla prossima,
Mike

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Should Endowment Funds Just Index?

The FT’s Chris Flood has stepped into a minefield by writing this article (“Leading U.S. university endowments struggle to beat tracker funds”).

I mean, there are allocators who will spend a lot of time on Twitter explaining why articles like this fail to account for the intricacies of endowment management, etc., etc.

I think it’s fair for people to quibble with choosing a Vanguard index fund as a benchmark over the last decade.

And — not having read Professor Kaplan’s study referenced in the article — it seems a bit irrelevant to argue that U.S. buyout funds generated 350bps of alpha over the S&P 500 since 1986. There’s no investable index for buyouts. Think of the odds of selecting the index-performing manager each time for however many vintages it takes to construct an index extending across 30 years.

Anyway, there are only two questions that matter:

  1. Has private equity delivered for endowments?
  2. Are endowments / investment consultants / OCIOs any good at manager selection?

The article doesn’t dive into these, but I went to the 2018 NACUBO-TIAA Study of Endowments to find a rough proxy.

The chart below shows the 10-year net returns by endowment size, with each cohort’s dollar-weighted allocation to PE as of FY 2018.

Screen Shot 2019-12-17 at 9.43.59 AM.png

So, 1. Has PE delivered for endowments?

If PE — as an asset class — delivers, then we’d expect the columns on the left to be meaningfully taller than the ones on the right, since that’s where there’s a greater allocation to PE.

They’re not.

2. Maybe the columns on the left aren’t meaningfully higher because many endowments / investment consultants / OCIOs aren’t that good at manager selection?

Look, the proxy’s imperfect — we’d like to see the PE allocations over time, as well as by median vs. top-decile institutions. Some endowments are actually good at manager selection. PE and VC are great if you can get into the right funds. But by definition, not all endowments can do that.

What do you think?

———

The Barometer

Coller Capital’s Winter 2019-20 Global Private Equity Barometer is out.

Here are the two non-revelatory takeaways for EM:

Picture3

Picture4

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From the Bookshelf

[M]y sympathies are with the predator, not with the hunted, perhaps because a lion is perceived as an individual, whereas one member of a herd of thousands seems but a part of a compound organism, with little more identity than one termite swarm.

— Peter Matthiessen, The Tree Where Man Was Born (Penguin: 1995)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

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