Market veterans see signs of momentum for liquid private equity

Following years on the fringes of the money management wilderness, liquid private equity strategies could be edging at last toward the industry mainstream, market veterans said.

People are increasingly "embracing the idea that there's a way to replicate the same risk and return characteristics that you find in private equity with listed securities," opening the door for more conversations with institutional asset owners, said Jeffrey F. Knupp, president of Chicago-based private equity replication boutique DSC Quantitative Group LLC.

Among those conversing now: the $458.9 billion California Public Employees' Retirement System.

CalPERS contacted DSC — whose founding in 2012 makes it one of the oldest kids on the private equity replication block — to explore the kind of role these strategies can play as a complement to the pension fund's announced plans to boost allocations to segments such as venture capital, Mr. Knupp said.

Spokespeople for Sacramento-based CalPERS didn't immediately respond to requests for comment.

Private equity replication managers mix exposures to publicly listed equities with leverage to match the returns asset owners garner by investing in diversified portfolios of privately owned companies, with the added charms of vastly greater liquidity and sharply lower fees.

Some also hedge their portfolios to simulate direct private equity's relatively steady performance during periods of market turbulence that results, in part, from more glacial price discovery. Others opt to take advantage of the day-to-day pricing information offered by publicly traded shares. That difference has found a number of managers enjoying similar success when the market has rallied - for example, roughly matching the 28% gain of the Refinitiv Private Equity Benchmark index in 2021 - while reporting more scattered results for years of market stress such as 2022.

Proponents of private equity replication strategies see potential demand from big asset owners with broad-based private equity and venture capital programs accelerating as well as from smaller institutional, high-net-worth and even retail investors lacking the scale to construct well-balanced exposures.

"This is a nascent space but we think we're on the cusp of something really big" — in the same way private equity secondaries became a distinct market segment over the past 15 years, said Jean-Louis Lelogeais, who co-founded Boston-based liquid private equity boutique PEO Partners LLC in 2019 with Harvard Business School professor Randy Cohen, in a recent interview. Mr. Cohen, in the same interview, predicted potential demand for replication strategies could eventually be in the "hundreds of billions of dollars."

It's a "trillion-dollar idea just waiting to happen," agreed Allan Seychuk, vice president and senior investment director of alternative investments with Mackenzie Investments. The Toronto-based firm launched a liquid private equity offering for Canadian investors two and a half years ago in tandem with PEO Partners.

For big institutional investors, private equity replication strategies help "solve the illiquidity and capital allocation problem," allowing them to garner private equity-like returns while their commitments are called down and distributions are put back to work, Mr. Seychuk said. For smaller institutions or individual investors, it helps solve the problem of access to an asset class they would otherwise not have sufficient scale to invest in, he said.

Mackenzie's liquid private equity fund currently has roughly C$220 million in assets under management. PEO Partners' AUM, which includes a U.S. fund and the Mackenzie assets it provides advisory services to, comes to roughly $180 million. DSC, Mr. Knupp said, manages "a few hundred million" in private equity and venture capital replication assets.

Opinions vary on whether institutional or retail investors are likely to drive the pickup in demand over the next few years.

Michael Even, who served as CEO of Numeric Investments when that quant firm was developing the private equity replication strategy it launched in May 2018, said integrating a portfolio of publicly traded stocks into a private equity program comes with its own set of organizational challenges for institutional investors.

"It's not 100% clear," for example, where private equity replication fits within a broader asset allocation framework — whether the private equity team or the public equity team would have ownership, he said.

So, while uses such as managing liquidity for private equity commitments or recycling distributions should attract institutional interest, finding internal champions willing to push ahead could remain a hurdle, potentially making retail investors a stronger near-term prospect, said Mr. Even. Since retiring from Numeric in 2017, he has been serving on a number of boards and advisory committees.

Mr. Seychuk said his team anticipates interest from both institutional and retail investors in Canada for MacKenzie's strategy but he expects institutional demand will lead the way.

Mackenzie's track record is still six months shy of the three-year numbers needed to populate institutional databases but once it crosses that threshold "we expect … interest to really pick up," with rising institutional flows signaling to retail investors that liquid private equity should be of interest to them as well, he said.

If the demand side of the liquid private equity equation looks set to gather momentum now, the supply side could likewise be poised to move beyond the handful of firms — including DSC, MacKenzie, Numeric Investments, PEO Partners and Boston-based Verdad Capital — which have led the way until now.

Those boutiques, with combined assets under management of roughly $1 billion, could come to be seen as just the "tip of the iceberg" in the not-too-distant future, predicted Mr. Lelogeais, citing a "long list of serious people … working on this now."

The evidence? Multiple conversations this year with investment veterans at bulge-bracket money management firms who cut off market intelligence exchanges with PEO Partners on the basis of plans to bring out their own liquid private equity strategies, saying "hey, we have a lot of respect for you guys (and) we don't want you to feel like we stole your ideas," Mr. Cohen said.

Mr. Lelogeais, while declining to name the firms looking to launch strategies now, welcomed the competition, saying the space remains nascent enough to leave the focus on creating a market rather than fighting to become a bigger fish in a very small pond.

"In some sense, we want everybody to succeed," Mr. Lelogeais said.

The strategies currently on offer from the boutiques in the liquid private equity space, meanwhile, haven't become commoditized, with each offering its own mix of publicly listed equities, leverage and hedging to deliver private equity-like returns to clients.

PEO Partners, for example, focuses on the small- and midcap targets of leveraged buyouts, with a strategy to "buy what they buy," since industry selection is private equity's biggest source of alpha, "lever like they lever and protect the downside," Mr. Cohen said.

DSC, by contrast, focuses on large-cap stocks and doesn't hedge its current lineup of private equity replication beta strategies, reflecting its investment team's belief that the resilience private equity valuations have traditionally shown when markets plunge is more "stale pricing" myth than reality.

"Whenever you have liquidity, you're going to have a true valuation," noted Arthur R. Bushonville, CEO of DSC Quantitative. "When you don't have liquidity, then you're marking (your private equity exposures) to a price which may or may not trade," setting the stage for the kind of stale pricing where the denominator effect comes into play, he said.

Still, DSC executives conceded that for big asset owners potentially sitting on commitments that could take 12 months or more to call down, hedging downside volatility on a portfolio of leveraged, publicly listed stocks could have some appeal.

On June 27, DSC announced that as early as July, it will bring out the first of a number of new liquid private equity strategies, benchmarked to Boston-based Cambridge Associates LLC's global private equity and venture capital indexes, which will include hedging to manage volatility.

By contrast, Messrs. Lelogeais and Cohen at PEO Partners said they may come out with unhedged strategies in the future.

Dan Rasmussen, founding partner at Verdad, said his firm invests mainly in microcap stocks with debt on their balance sheets that replicates private equity exposures, as opposed to relying on the options or margin leverage other strategies employ.

Mr. Rasmussen said Verdad manages roughly $500 million in private equity replication strategies, with $230 million in its opportunity fund and the other $270 million spread across two funds that invest in Japanese equities, as well as one Europe-focused fund and one global fund.

In another sign that legacy private equity replication boutiques see their market segment entering a new phase of growth, executives at both DSC and PEO Partners said they're pursuing talks now with potential distribution partners that would give those firms the resources they would need to reach a much larger audience.

DSC's search for a partner — whether that turns out to be one partner globally or a number of partners for different regions — is the firm's first since its launch in 2012, noted Mr. Knupp, calling the move a reflection of how the market "has grown and evolved" over that time.

Likewise, PEO Partners' Mr. Lelogeais said his firm is having a number of strategic conversations now looking for "the right partner that could help us take the business to the next level." Those wide-ranging talks include quant firms, big asset owners and big registered investment advisory firms, which could offer great distribution, he said.