Aligning listed and private equity cultures can be quite tricky, David Brown says.
The total portfolio approach requires all asset class teams to consider their contribution in light of the overall investment portfolio. Do their investments add diversification, increase returns or mitigate risk when taking the rest of the portfolio into account?
It is a sound philosophy, since the end beneficiary only deals with the results of the total portfolio, not with the performance of the individual asset classes.
But overcoming the cultural differences inherent in the various approaches to investing is not always easy.
In a recent podcast interview with David Brown, Chief Investment Officer of the Cook Islands National Superannuation Fund, he illustrated how different the approaches between listed and private equity teams can be.
Brown especially pointed to the philosophical differences between the efficient market hypothesis thinking of many listed market investors and the private equity idea that alpha is generated from repositioning assets.
“[Private equity] challenges people who come from an efficient market hypothesis background, [because the unlisted market] is not a perfect market,” he said in an interview for the [i3] Podcast.
“You buy a company, you change its capital structure, and like some Heisenberg effect, where the observer actually changes the outcome, you are the observer. It’s the alpha of change.
[Private equity] challenges people who come from an efficient market hypothesis background, [because the unlisted market] is not a perfect market. You buy a company, you change its capital structure, and like some Heisenberg effect, where the observer actually changes the outcome, you are the observer. It's the alpha of change.
“If you’re brought up in that efficient market hypothesis approach where alpha is not a consistent stream of return, it makes it very difficult to think of a market where there are information asymmetries and the investor is actually changing the investment instrument by being present.”
He recalled an example when he worked at the Victorian Funds Management Corporation under Leo de Bever, who was CIO from 2006 to 2008, when the private equity team was considering taking a position in a series of fund-of-fund investments.
“[There was] a US college that had a liquidity problem and they wanted to get rid of their portfolio of venture [capital]. And in buyout in private equity, there is a very clear way to measure what a secondary position is going to cost, but in a fund-of-funds position that didn’t exist in those days, certainly not in venture,” he said.
“So you could see what the gap [was] between what we were going to have to pay, which was an awful lot lower than actually even the discounted secondary positions in the primary funds. These were enormous discounts that were really only available because it was a dislocation in the market.
“And I remember an investment committee [meeting], where we were talking about, I think, a volatility arbitrage [trade where] we put about a billion that way and a billion the other way, and you make two smidgens of basis points of performance.
“We spoke about that for about two or three hours. And then we came along with between 40 to 60 per cent discounts to book [value] on this venture [deal].
“And I think I frightened people. I think there was a genuine sense of but how would you value that?
“I think it was just so jarring … to have such discontinuities emerge in that efficient market hypothesis framework of thinking of the world. This didn’t compute. So the water cooler discussion does break down because our experience is so different.”
For the full podcast interview, please see here.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.