Some boutiques that mix public equity exposure with leverage to deliver private equity-like returns for clients insist that such resilience during periods of market turbulence is something investors want and expect from replication strategies — despite being attributable, in part, to glacial price discovery for companies that only get revalued at the time of a new funding round or an initial public offering.
Including successful downside protection at reasonable cost "is critical to truly replicating the investment characteristics" of directly investing in private equity, said Allan Seychuk, vice president and senior investment director of alternative investments with Toronto-based Mackenzie Investments.
Even if that resilience in turbulent markets can be tied to not having to price investments every day, "that's what investors are looking for the strategy to do," Mr. Seychuk said. Strategies that fail to do so will disappoint investors or even turn off potential clients, he said.
The private equity replication strategy Mackenzie launched two and a half years ago, with C$220 million ($167 million) now in institutional and retail assets, was able to deliver that sought-after low volatility last year with the help of a hedging "collar" employing puts and calls, Mr. Seychuk said.
After surging 28.1% in 2021, in line with benchmarks such as the Refinitiv Private Equity Buyout Benchmark index's 27.5% gain for that year, Mackenzie's strategy gave back a mere 6% in 2022, a fraction of Refinitiv's 21.7% decline.
Every private equity replication manager focuses on outperforming public equity benchmarks by an annualized 2 or 3 percentage points a year but "you need to deliver both (outperformance and low volatility) to be a true private equity replication strategy," said Mr. Seychuk.
Thus far, providers have focused more on returns than on downside protection, which in turn may be slowing investor uptake for those strategies, he said.
By contrast, Jeffrey F. Knupp , president of Chicago-based private equity replication firm DSC Quantitative Group LLC, sees the more transparent, up-to-date price discovery offered by the public equity exposures central to private equity replication strategies as something capable of attracting considerable institutional interest as well.
For the several hundred millions of dollars DSC manages for clients now, the firm is looking to replicate "what's truly happening in private equity and venture capital, even if it happens (with) a lag," said Mr. Knupp.
In that regard, Mr. Knupp contends, the ability of private companies to withstand market shocks that batter their public market counterparts is largely illusory.
"We firmly believe that the form of ownership" — public or private — "doesn't matter," he said.
By way of example, Mr. Knupp pointed to last year's more than 80% plunge in value for two companies in the "buy now, pay later" space – Nasdaq-listed Affirm Holdings Inc. and privately held, Stockholm-based Klarna, which only got repriced because it couldn't put off another funding round.
If there are two companies with similar businesses and balance sheets and the public one is sold off 15%, why would the private company fare materially differently, he asked.
Consequently, DSC doesn't hedge its existing lineup of private equity replication beta offerings, he said.
"A lot of institutional investors (want) to hedge themselves at the portfolio level," noted Arthur R. Bushonville, CEO of DSC Quantitative. "They want the true returns of the asset class" as opposed to incorporating a hedged product into their portfolios, he said.
DSC's replication strategies have tracked the investible indexes tied to the Refinitive PE benchmark series, with gains of 37.4%, 25.6% and 29.8% for the three years through 2021 followed by a 31.1% drop in 2022.
The much smaller declines for asset owners investing directly in private equity, on the back of stale pricing, may feel good but "it's not where the market is," Mr. Knupp said. The numbers DSC's clients see should be much more representative of what's really happening in the market, he said.
Still, rather than harden into two opposing camps, there are signs industry players believe there is business to be attracted with hedged and unhedged replication strategies alike.
On June 27, DSC announced it will launch its first volatility-controlled strategy benchmarked against Boston-based Cambridge Associates LLC's global private equity and venture capital indexes in July — a strategy that could have some appeal for clients with considerable amounts of dry powder commitments to private equity funds that can take a year or more to be put to work, Mr. Knupp noted.
Randy Cohen, who co-founded Boston-based private equity replication boutique PEO Partners in 2019, which partnered with Mackenzie in structuring the Canadian firm's offering, likewise expects more managers in the space to play on both sides of the hedging question.
While the strategies PEO Partners advises in the U.S. or subadvises in Canada all include hedging, "we may introduce unhedged products" as well in the future, Mr. Cohen said.
It's a perfectly good product for people who "understand the risks and recognize that it's not going to have that low marked volatility that PE delivers," he said.
