Public vs. Private Investments
There’s a misconception in finance, and it’s not a small misconception—in fact it’s quite rampant, from the average mom-and-pop investor to the corridors of high finance. That misconception is this: “private always outperforms public.” The question to ask is: is this actually true?
First, what does it mean when people say private always outperforms public?
I don’t want to assume your knowledge here so, just as context, the public investable universe is only part of the investment market available to investors. In other words, the stock market only represents the “public”—or listed—stocks. The other part of the investable market consists of private investments—those investments that aren’t listed on public stock, bond, or commodity exchanges, but which have comprised a larger and larger part of where investment is located over time. For stock, this is the realm of private equity and venture capital investors. And whereas venture capital invests at the earliest stages of a startup’s life, private equity often invests in either growth-stage or mature businesses. This is roughly the investment landscape before a company’s Initial Public Offering (the moment where they “go public,” i.e., list on a public exchange like the NASDAQ or NYSE).
So when people believe “private always outperforms public,” what they’re saying is that they believe these private equity investments—the early investments in startups, the growth investments, and the buying and selling of larger privately-held businesses—collectively outperform those opportunities offered by publicly-listed companies. And the question we’re wanting to ask is, despite widespread belief, is this actually true?
There’s four main things to consider in this conversation:
Firstly, public equity markets often provide higher liquidity compared to private equity markets. In public markets, shares are traded on established exchanges, allowing investors to buy and sell assets quickly and with relative ease. This liquidity is a significant advantage, especially during periods of market volatility or when investors need to reallocate their portfolios swiftly. In contrast, private equity investments are typically illiquid, often requiring investors to commit their capital for several years with limited opportunities for early exit. This illiquidity of private markets also masks or “smooths out” volatile periods because of the lack of information.
Secondly, public equity markets offer greater transparency than private equity markets. Publicly traded companies are required to disclose financial information regularly, adhere to stringent regulatory standards, and are subject to the scrutiny of analysts, media, and the investing public. This transparency allows investors to make more informed decisions, assess company performance accurately, and manage risks more effectively. In contrast, private equity investments often lack this level of transparency, making it more challenging to evaluate and monitor investments.
Another point to consider is the potential for higher returns in public markets due to market efficiency. While private equity can offer substantial returns, particularly in early-stage investments or leveraged buyouts, these opportunities are not accessible to all investors and come with higher risks. Public equity markets, by virtue of being more efficient and having a broader range of investment options, can offer competitive returns that, over time, may outperform those of private equity. Additionally, the ability to diversify investments in public markets reduces risk, whereas private equity investments are often concentrated in a few holdings.
Finally, the cost structure of public equity markets is generally more favorable than that of private equity markets. Public market investors typically incur lower fees, as the cost of managing public equity portfolios is usually less than the management and performance fees charged by private equity funds. Over time, these lower costs can significantly impact net returns, potentially making public equities a more attractive option for long-term investors.
With these factors in mind, let’s look at the crux of the issue: how does financial performance compare for private versus public markets?
One interesting answer comes from Dimensional Fund Advisors (DFA). They write:
“So, how do we compare private fund performance to public markets? We use two primary methods supported by the academic literature: the Kaplan-Schoar Public Market Equivalent (KS-PME) and the Direct Alpha. We use these to examine buyout, venture capital, private credit, and private real estate funds against multiple public-market indexes. Our findings suggest that the choice of public-market benchmark is highly influential on measures of the opportunity cost of private investments.
For example, the lifetime performance of the average buyout and venture capital fund in our sample compares favorably to the S&P 500. However, this outperformance shrinks considerably when we compare buyout funds to the Dimensional US Large Value Index and venture capital funds to the Dimensional US Small Cap Growth Index, and it disappears or turns to underperformance compared to the Dimensional US Small Value Index.”
So to the question of whether private actually outcompetes public, the answer is, “It depends.” It depends on the benchmark used for comparison. But as noted earlier, financial performance isn’t the only factor. Dispersion of performance matters also.
DFA’s researchers write:
“Consider buyout funds, for which we have data on vintages from 1986 through 2022. The lifetime IRR (measured 15 years after fund inception) is -6.09% for the 5th percentile fund, 11.41% for the average, and 28.86% for the 95th percentile. For venture capital funds from 1980-2022, the corresponding figures are -15.91% (5th percentile), 13.43% (average), and 43.15% (95th percentile). The range of lifetime IRRs for private credit funds from 1993-2022 is -5.31% (5th percentile), 9.72% (average), and 20.58% (95th percentile). Lastly, for private real estate from 1993-2022, the figures are -10.53% (5th percentile), 6.10% (average), and 18.19% (95th percentile).
This dispersion is an important consideration for investors thinking about investing in private assets. In public equity markets, it is straight forward to hold a broadly diversified group of stocks. However, “holding the market” is difficult in the private space, with generally high investment minimums, less transparency in holdings, and more difficulty accessing or monitoring managers. This exacerbates the issue of selecting a manager.”
In other words, the dispersion of good performance from bad performance is much more pronounced in private markets than public markets—and diversifying (the usual method of mitigating the risk of such dispersion) is a more challenging proposition in private markets for the reasons they mentioned.
It’s easy to see all this as just numbers in a spreadsheet. But the startups you’ve heard about for years, from major success to catastrophic failure, are all part of this story too. And consider the recent spate of tremendous startup failures from the tech sector (with billions in investor dollars incinerated):
Theranos: raised $700 million in private venture funding, ended in bankruptcy and with the founder going to jail for fraud
WeWork: $16 billion raised in private venture funding, currently on the brink of bankruptcy as a public company
Juicero: $120 million raised, ended with bankruptcy
The venture capitalists deploying these enormous sums also raise funds themselves from limited partners, and often these limited partners include the large pension funds, family offices, and more-recently RIA firms, that invest money on behalf of pensioners and investors across America. So while WeWork investment may be a clearer case of a Japanese businessman (Masayoshi Son at SoftBank) lighting Saudi money on fire (through SoftBank’s “Vision Fund,” whose backers were mainly Saudi), many startup failures are gambling with pensioners money—which is its own conversation on how desirable or even justifiable that is as a common practice.
In sum Optimus would consider most investors unsuited for the private markets, given those markets’ lack of liquidity, their lack of transparency, their inefficiency, their disadvantaged cost structure, and—ultimately—the reality that financial performance is far more varied in private markets than their public counterparts, and when closer benchmarks are selected, the outperformance essentially vanishes.
