Episode Transcript
Greg Brown:
The paradigm that's being used now to describe, you know, what private equity does is along three
dimensions. One is, you know, financial issues, so think of it as like financial operations and
governance, another is sort of the true underlying operational issues for a company, and the third is
sort of a governance thing.
Indrani De:
So hello everyone, I'm Indrani De, Head of Global Investment Research at FTSE Russell and I'm
delighted today to be joined by Greg Brown. He's a Professor of Finance at the Kenan-Flagler
Business School University of North Carolina at Chapel Hill and also a Research Director at the
Institute of Private Capital. A very warm welcome, Greg. Delighted to have this session on private
capital with you.
Greg Brown:
Thank you. I'm delighted to be here.
Indrani De:
Give us a little information about what you're doing and a little bit about the journey that brought
you to this point.
Greg Brown:
So I've been an academic researcher, faculty member at UNC for more than 25 years now. Came
straight out of my PhD program to be an academic researcher and a teacher. I started out as sort of
a risk management type person. That turned into an interest in alternative investments, and lately
I've been doing private equity and private fund research mostly. It’s certainly been an interesting
journey to have an academic career for twenty-five years.
Indrani De:
Any pivotal moment in your career that you say might have had a tremendous impact subsequently?
Greg Brown:
I mean for me, I think it was the financial crisis. You know in 2008. I would say as an academic I think
I was a little bit embarrassed for the profession and sort of how flat-footed academics were in the
response to the financial crisis, just in the sense that I think we were as shocked as everyone in
terms of just what the systemic risks were that were in the financial system that were largely
unknown. And I think there wasn't a good understanding of things like, you know, private label
RMBS and CDO’s and just you know how big they had gotten and how risky they were.
For me, that was a sign that I think, you know, academics really needed to take a more active role in
trying to understand current issues and what important topics were. And hopefully there aren't
other systemic risks you know out there, but certainly having an eye towards kind of what's current
and forward-looking versus just, you know, sort of historical backward-looking empirical work.
Indrani De:
That brings us to the interesting point. You mentioned what's happening currently. It's very
important to kind of keep an eye out on that. So when people talk about the general
outperformance in private markets, now let's say specifically in public equity related to private
equity with private equity outperforming, is it only a question of the leverage returns to having
leverage, or is there something deeper that's driving this outperformance in private markets?
Greg Brown:
This is a question that's being pretty actively debated. I have, I think, a fairly strong opinion that
private markets are not simply just, you know, sort of levered up public assets. Maybe the most
obvious place to see that is venture capital, right? Because, I mean, venture capital doesn't have any
leverage for the most part, mostly unlevered investments. Yet they're still very risky. Right, we know
that they're, they're quite risky. It's just the nature of investments are different, right? Just those are
companies that just aren't ready for public markets yet. And you know maybe that's too obvious of
an example because obviously buyout space is quite a bit different than venture capital. But I think
when you look at the companies that are privately held now and even the companies that were
publicly held and taken private, they're different, right? They tend to have safer underlying asset
characteristics. So especially the companies that are taken private tend to, you think of them as
having lower asset betas.
But I think private equity brings other things to the table in terms of, you know, how the assets are
managed and sort of the paradigm that's being used now to describe, you know, what private equity
does is sort of along three dimensions. One is, you know, financial issues. So think of it as like
financial operations and governance. Another is sort of the true underlying operational issues for a
company. And the third is sort of a governance thing. I guess the way I think about it is, sort of, the
governance is the most important one because you're going from something that's sort of broadly
held in public markets, let's say to something that is a concentrated ownership position. So you're
kind of doing away with some of the traditional agency issues that are there and then that lets you
undertake sort of financial and operational engineering. Financials definitely part of it, right? We sort
of have done studies to try to understand where returns come from and leverage is definitely part of
that.
But there's also a lot of operational improvement. And I think as private equity has evolved over
time, or at least the buyout space has evolved over time, there's been a movement away from the
bulk of the gains coming from financial engineering towards more operational and growth types of
strategies.
Indrani De:
That's a very interesting observation on the operational issues and the nature of companies being
different in these two spaces. Digging deeper into other parts of private markets, do you think
there's an inherent shift that's going on, let's say, from private equity to private credit and maybe
from real estate to infrastructure?
Greg Brown:
Without a doubt, infrastructure and private credit have just been, you know, on fire lately and just
the amount of fundraising that's happening there has just really been astronomical. And in both
cases, yes, the growth has been post-financial crisis, right? It's been, it's really been the last ten
years, fifteen years or so. But I think there's different reasons there. I think in private credit, you
know, what's happening is that there's been as much as anything a regulatory reason for this in the
sense that banks, you know, pulled back from at least doing the riskiest part of lending and sort of
buyout space. I think that gave lots of good ideas to people for other things they might do and sort
of led to, you know, innovations in terms of deal structuring and, you know, other sorts of services
that private credit lenders might provide.
In infrastructure, I think it's a bit different. I think there it was maybe driven as much by sort of a
search for yield and that, you know, people saw that there were these large kind of institutional
quality assets out there that could be put into portfolios and managed in a way that was quite
competitive with real estate returns, and public fixed income returns, for example. Now, are they
going to displace real estate and buyouts? I don't think so. I think we'll continue to see growth in, in
real estate private funds and in buyout funds. But they're certainly growing much faster. And I know
that some people who are much more knowledgeable about this space than me in the industry say
that private credit could get to be as large as private equity, right? And I think the same could be said of infrastructure in real estate. You know, I think, just the growth in the number and the size of
funds and infrastructure could have them exceed the committed capital in private real estate. Lots
to watch and keep track of there, for sure.
Indrani De:
Indeed. Which brings us back to another question on private equity. Like we talked about how
it has been having outperformance over public equity, but we also know there are changes going on. There's a stalling in the exit activity. So what would you say is the current status of private equity?
Greg Brown:
Yes. I mean, I wish I knew in some sense, right, because it's really hard to tell, right? I mean, like
we're not really gonna know until we see a pickup in exit activity, right? The returns have not been
terrible in buyout land. I mean, venture has had some you know sort of double-digit negative
returns, as you would sort of expect from a very risky asset class and tech, in particular, getting
whacked around after sort of a pretty bubbly period through 2021.
It’s just hard to know, right? Are the current returns in buyout space are they because things haven't
been marked down that should be marked down? Or, is it just because it's been difficult time to exit
and so the valuations are good?
I mean, we have the exits we've seen have actually been reasonably good valuations. And so it isn't
like people have been forced to take, you know, big haircuts when they, when they have made exits,
at least in the buyout space. But maybe that's because only the good deals have exited so far, so I
think we will know a lot in three, or four, or five years when these things finally, you know, sort of
transact. It’s getting to be late stage for some of these funds in the sense that they, you know, are
contractually obliged to start returning capital. And we've seen sort of the average hold period for
buyout funds really extend tremendously over the last few years.
I’m certainly, as a researcher, anxious to see, you know, if the outperformance of buyout funds will
persist as we see sort of these more recent vintages start to liquidate.
Indrani De:
So, timing is critical. And keeping an eye out on the next four to five years is critical.
Greg Brown:
When you are committing capital now, it's money that's going to go to work in, you know, the next
five, over the next five years or so. I mean, I think in some ways it's probably a good time to be committing capital if you think that there's going to be funds that are forced to exit positions that they may not want to exit and valuations aren't going to be great. So, you know, it's a very sort of long-run asset class in the sense that you're making sort of these blind pool commitments for many years and so, you know, the money you commit today isn't going to actually go into the ground for several years probably. And then it's going to, you know, be another ten years potentially before you see the exits from that.
Indrani De:
Indeed. Now, tying this all back into the macro environment, obviously the last two years everything
has been about inflation and rates. So coming back to the question of inflation, do you think there
are key differences in the inflation sensitivity of public markets and private markets?
Greg Brown:
Yes, I don't think so, in sort of the equity space. But I think in the real asset space there probably is.
We've been doing some research on this recently and looking at infrastructure funds in particular.
What we've done is, is say okay, let's take a public market infrastructure index. We can obviously see what's inside of that, you know, what industries, what type of companies, geographies. It's harder to do that for private funds because just the data isn't as readily available for what's in private infrastructure funds. But we've been able to collect the holdings of at least the largest infrastructure funds and sort of classify what's inside of those funds.
What we find is that there is a difference in geography. It's a little more tilted. Private funds are a
little bit more tilted towards European than the public indices. And then also on the industry side,
you see sort of less exposure to communications, utilities, and private funds and more in industrial
space. People who know the private fund space think, oh well that's a little suspicious maybe, like,
“What's an industrial infrastructure company?” Are these big asset managers just sticking buyout
deals inside of infrastructure funds and calling them infrastructure?
But when we look at the actual deals we do see that they are things, they’re like marine port services or airport services or things that look like they're at least, you know, related in a way to
infrastructure type assets, but perhaps more operational and service oriented than a toll road, you
know, or a utility, a traditional utility. In that sense, we think that part of the relatively good
performance we've seen in private infrastructure the last couple years may be related to the pricing
power that some of these services companies have versus kind of traditional utilities or traditional
kind of public, private type assets.
And then we also think that the duration of these assets is, is probably quite a bit lower and because there's been such a big increase in real rates, some of the real estate and infrastructure assets that have sort of very long cash flow duration have been more adversely impacted by that big increase in real rates versus say a services company that's going to have a shorter duration of cash flows and more inflation, ability to adjust revenues to inflation pressures more easily.
Indrani De:
So that's interesting. So pricing power, duration, geographic exposure, and industry exposure.
Greg Brown:
Yes, there's a lot of moving pieces, but we think we can explain kind of what these return differences are being caused by.
Indrani De:
That's very interesting. One more question that really fascinates us, see FTSE Russell, being we have indices in different asset classes. So the whole issue of investability is very important, right? So
coming to the question of scale or capacity or diseconomies of scale or economies of scale, what
kind of differences do you see and, you know, your thoughts there.
Greg Brown:
Yes, I mean, it's a question that I think is front of mind for a lot of people that are thinking about
increasing exposures to private markets, right? Because there's this question of how much room do
they have to grow, right? So especially if you're, say, moving in, you know, massive amounts of say
retail money. Say you start seeing big allocations from either, you know, high net worth individuals
or even, you know, there's been talk about having private funds allocation inside of DC plans, right?
So could the private fund industry absorb another five or ten trillion dollars of capital? I mean that's
a really interesting question.
Some people believe that returns have moderated in asset classes and buyouts in particular. So we
actually just did a study that was Institute for Private Capital study looking at the relationship
between scale in different strategies and returns. And what we found is that there is clearly
variation, time variation in performance by asset class across all of the private asset classes. But
there don't seem to be meaningful trends and especially downward trends over time. There was a
dip in performance around the global financial crisis for most of these asset classes, but they've
done quite well the last ten years. So it doesn't seem like as the assets, in say, buyout space or
venture space have increased dramatically over the last decade that there's been, you know,
substantially lower returns.
Now, we also look at sort of the growth at the GP level or even the fund level. So when the GP
increases the amount of money that it’s managing and from one fund to the next does that lead to
lower performance? We also don't find much there. It doesn't seem to matter one way or the other.
It’s kind of counter to what a lot of people's intuition has been and even some of the folklore in the
industry but there's just not strong results there. So, I would say, I can't say for sure that, you know,
the industry could absorb another five or ten trillion dollars in assets, but at least to date, the growth
has not resulted in sort of obviously lower performance.
Indrani De:
So much more room to go in the near future.
Greg Brown:
Well, I think the industry certainly hopes that's the case. And there's been a bit of a pause in
fundraising lately, so we’re probably going to be resetting off of a lower base over the the next five
to ten years.
Indrani De:
Fascinating insights, Greg. Thank you so much for sharing your insights with us.
Greg Brown:
Yes, my pleasure. Thanks for having me
