If Prof. Malkiel had taken his “Random Walk” in Midtown Manhattan, the private capital industry’s enclave, he could have found that prices can be “less wrong” there than down Wall Street – to a level that could offer, over the life of a private fund, reasonable arbitrage opportunities but not without risk.
Even if “future cash flows can only be estimated and are never known with certainty” and “equity risk premiums are unlikely to be stable over time”, GPs tend to know better (and have the tools to influence) how much their portfolio companies could be worth (i.e. the valuation/price they could be traded for).
What GPs do not and cannot anyway know or control is when market conditions will be favourable for the portfolio companies to be actually traded at the targeted valuations/prices.
The “possibly right” assumptions that GPs can make about cash flows and exit multiples are challenged by ever-changing market conditions.
Investors can find clues to “rationally” take advantage from GPs’ insight and determine “less wrong” prices if they perform their analyses within a diversified capital asset pricing framework:
- Detect divergences, to gauge if and how much “future value” is already embedded in a fund’s S-Curve (not a typo, please see previous post). If NAVs are marked to the potential, “possibly right” prices expected to be obtained in future exits, there may be differences between these prices and what may be obtainable in the market (as reflected by the interim mark to market exercises) before the actual exits;
- Tie “possibly right” future values and NAVs, eventually adjusted using identified divergences and probabilistic information drawn from the public markets, by superimposing “beta + premium” return expectations. A recent academic paper that analyses the “Investment Beliefs of Endowments” provides a pretty good picture about the size of the premium expected by that influential cluster of investors, highlighting anyway that their expectations show an optimistic bias.
The time-constrained, self-liquidating nature of private capital funds helps making the process less wrong. When marginal returns start decreasing, they keep decreasing as the maturity of the fund (plus eventual extensions) gets close.
Time always takes its toll.
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