Thoughts on Mispriced Assets

Luck, Skill and Out-Performance in Private Markets (Part 2)

In my first piece in this series on persistence, I argued that to minimize the impact of luck, investors can either try to up their own skill or look for games that have better odds and better payouts. In this piece, I’ll focus on an idea with better odds and better payouts.

GAMES OF LUCK

Roulette provides an extreme example of investing in an environment where luck is the only variable in the outcome. For those who aren’t familiar with roulette, here is an overview and 3 simple bets for illustration. There are 38 numbers on a roulette wheel; 18 red, 18 black and 2 green (numbered 0 and 00).

Each game of roulette is independent of the last. It’s not a deck of cards like blackjack or poker where the odds change during the game and there is some skill in recalculating the odds or playing the other players. The house takes 5% of every $1 bet and there is nothing a player can do about it other than just try to have fun or look for a different game.

Roulette is obviously NOT the same as investing in private markets. First, private markets still have a positive expected value and it does involve skill for Limited Partners in how they invest. But roulette provides an interesting control for exploring one of the primary levers of skill available to Limited Partners… looking for investment opportunities with better probabilistic outcomes.

Limited Partners have 3 fundamental tools available to generate alpha;

1) Lower the fee burden

2) Manager selection (I will explore this tool in Part 3 of this series)

3) Tactical allocation decisions

In my mind, tactical decisions are a little like finding games with better probabilistic outcomes. Either the frequency of winning is higher, or the magnitude of payout when you win is higher for the same price. Common tactical decisions include developed vs. emerging markets, larger cap vs. smaller cap strategies, buyout vs. venture and many others. Investors form a view that one sub-strategy offers a higher probability of success and tilt their allocation in that direction. The life cycle of a firm offers a unique and often overlooked tactical decision.

In a separate piece titled “6 Reasons to Consider First-Time Funds”, I explore 5 different data sources that strongly suggest first-time funds provide a compelling risk adjusted return compared to the overall PE market. For instance, data from Preqin[1] shows that the median return of first-time funds from 2002–2017 was higher than established funds 93% of the time. (15 out of 16 years)

Even if you had the perfect foresight to pick the one vintage when established firms outperformed, you only outperformed by 60 bps. Sticking with the roulette example, let’s eliminate skill (manager selection) from the equation; you simply have 1 decision; first-time funds or established funds. The first-time fund offers a bet with a 93% probability of outperforming and a better payout ratio. If a roulette wheel offered these odds, we could move to Vegas and break the house.

Games of Skill

Now let’s add in some skill. We’re no longer simply betting on median returns of first-time funds vs. established funds. Now let’s assume LPs possess manager selection skill. In a separate analysis by Cepres, they compare top quartile of first-time funds vs. established funds which shows that focusing on life cycle is even more rewarding for LPs. There is a 400–500bps premium for picking specific first-time funds vs. applying that same skill to more established firms. [2]

Like gambling, successful investing requires an ability to identify superior risk/reward propositions; situations where the odds are in your favor either due to the frequency of being right or the magnitude of the payout compensates you enough to overcome when you are wrong. And a really great opportunity would provide both frequency & magnitude. Those are the mispriced opportunities that lead to better outcomes.

So far I’ve argued that persistence no longer exits and the probability of reward is higher for younger firms. Of course this does not mean all first time funds are better bets than established managers nor does it mean that some established managers aren’t good bets. Stay tuned for my third and final installment in this series where I’ll address manager selection and the challenges of relying solely on that skill to generate good outcomes.

[1] Customized 2020 Preqin Global Private Equity & Venture Capital Report; data presented with latest available figures as of 3/4/20. All percentages are estimates. >6,000 funds in the Preqin database

[2] Cepres — Competing in a Saturated Fundraising Environment Spring 2020. Data collected from 5,168 funds in CEPRES database. Pooled returns represent the net return calculated on the aggregate cash flows and market values as reported by individual fund managers.