Public vs. Private Equity – Monkeys vs. Innovators and Explorers

Public equity is outperformed by private equity, just look at last decade’s private equity boom. This is the conventional wisdom, but in recent years a number of researchers have cast doubt on this and in some cases found that private equity underperformed dramatically. Private equity has no index that you ‘passively’ invest in, whereas – as suggested in Malkiel’s ‘A Random Walk Down Wall Street’ – “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” Indeed, a number of experiments have shown that randomly picked portfolios of publicly quoted stock can outperform portfolios picked by professional investment managers - the ‘monkeys’ won. Private equity, however, requires selection skills, something most comparisons between public and private equity do not factor in.

The LP voyage
Private equity’s attraction lies in the success of the limited partnership structure, the typical vehicle used for private equity funds. Such funds have investors as limited partners with the fund managers as general partners sharing 20% of the fund’s return as carried interest. In addition, private equity funds are self-liquidating - they have a limited lifetime of usually 10 years during which all capital needs to be returned to the investors. The establishment of the first private equity limited partnerships in the USA dates back to the late 1950s and 1960s. The long-term success of this structure contrasts with the demise of the original non-family VC firm: General George Doriot, the pre-WWII Harvard Business School professor, organized American Research and Development as a publicly traded, closed-end investment company. This pioneering organization’s business model ultimately failed while the limited partnership proved more adaptable and fit better with the business environment.

Although the partnership structure is often seen as an innovation for private equity investing, its origins date back to ancient times. For example, medieval merchants combined their capital with other merchants in one way or another, but they also financed their ventures and shared the risk in an asymmetric manner by accepting funds from small investors. Italian merchant families financed trade voyages through ‘commendas’. In this asymmetric partnership, the ‘sleeping partners’ were not liable for debt and stayed at home, while the ‘travelling partners’ controlled the venture and set sail to search for profitable business. The contract ended when profits were distributed after the merchant returned. The ‘travelling partner’ had a lot in common with today’s venture capitalist, in the sense that both have, at least initially, little more to offer than their skills and their risk-taking attitude. Private partnership contracts carrying limited liability could be of either Arabic or Byzantine origin. The associated profit-and-loss-sharing partnership is also embodied in the concept of Islamic finance, where one party provides 100% of the capital and the other, i.e. the “mudarib”, manages the venture using his or her skills. There is also a statute in the Code of Justinian and the Rhodian Sea Law, a 7th century body of regulations governing commercial trade and navigation in the Byzantine Empire that addresses partnerships. This ‘Lex Rhodia’ focused on the liability for lost or damaged cargo and divided the cost of the losses among the ship’s owner, the owners of the cargo and the passengers, thus serving as a form of insurance against the uncertainties of sea voyage such as storms or piracy. Voyages to discover new market place are just one form of exploration. It can relate to the search for resources as well: before the VC industry adopted this structure in the early 20th century, increasingly limited partnerships were used in the USA to raise capital for prospecting new oil fields. And exploration also relates to the new frontiers of technical innovation.

20% in history
An important aspect of the limited partnership structure seems of little relevance in public markets: fairness. For illustration let’s take a look at a comparable asymmetric setup in game theory: in the so-called ‘ultimatum game’ two players, a proposer and a responder, divide a reward. The proposition takes the form of an ultimatum whereby the responder can either accept the division or reject it, and if he rejects it, both players receive nothing. In economic theory the responder would accept any division in which his share was not zero. When researchers played the ultimatum game with monkeys they found that monkeys act as rational proposers and try to maximize their share of bananas whereas the responders usually reject no offer. Humans are different – we are not ‘rational’ in the economic sense, but act like arbiters of fairness. Many studies have run the ultimatum game across cultures and ages, and universally, people reject any share lower than 20% – apparently, as researchers hypothesise, to punish the greed of the proposer. Probably this model is as old as humanity – indeed, the asymmetric sharing of risks and rewards with a 20% carried interest for example appears to be mentioned in the bible, Genesis, Chapter 47: “Then Joseph said to the people, Behold, I have bought you this day and your land for Pharaoh: lo, here is seed for you, and ye shall sow the land. And it shall come to pass in the increase, that ye shall give the fifth part to Pharaoh, and four parts shall be your own, for seed of the field, and for your food, and for them of your households, and for food for your little ones.”

Evolving markets
Some observers wonder whether private limited partnerships are even beginning to challenge the public corporation as a form of corporate governance. However, there are two limitations: firstly, the model may not be scalable enough. The private equity industry can be described as inherently darwinistic – constantly evolving as a way of coping with the extreme uncertainty of innovation. The limited lifetime of a fund forces managers to regularly go back to the capital markets and ask existing or new investors to back the next fund. Rather than having a ‘magic formula’ that guarantees success, fund managers need to convince investors that they are better than other proposals around; this results in a high evolutionary pressure and requires private equity funds to adapt and differentiate themselves from others. Limited partners exercise ‘evolutionary pressure’ through selection and monitoring and are therefore an essential component of the ‘private equity ecosystem’. The scalability of the industry may thus be constrained by the lack of experienced limited partners that are likeminded and have a deep understanding of this activity.

Secondly, the strength of the public market lies in its ability to efficiently exploiting stable environments. In comparison, limited partnerships are expensive for their investors as rationality and efficiency is in effect traded off for risk appetite and adaptability. Despite long business cycles and short-term boom and busts in markets both forms need to co-exist. To come back to our oil exploration example: oil firms cannot only exploit existing fields nor can they only explore. Independent private equity firms regularly raising new funds with an asymmetric but fair sharing of risks and rewards is a textbook response to dealing with uncertainty – humanity’s timeless ‘killer application’ for exploration and for long-term economic growth.

Dr Thomas Meyer is head of risk management and consulting at the European Investment Fund

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