Private Equity Supports Efficient Markets (and why you should care)

1. What is Private Equity?

   • Private equity refers to investments made in companies that are not publicly traded. The goal is to achieve high returns by improving the company’s operations and then selling it for a profit.
   • Think of diamond-in-the-rough companies in which value is difficult to see, (but which you are assured is there). 

2. What is the Efficient Markets Hypothesis (EMH)?

   • The EMH states that share prices reflect all available information. It posits that stocks always trade at their fair market value, making it impossible to consistently outperform the market through expert stock selection or market timing.
   • Levels of Efficiency:
     • Weak Form: Prices reflect all available public information.
     • Semi-Strong Form: Prices reflect all public information and new information.
     • Strong Form: Prices reflect all information, including private information.
   • People who fancy themselves expert investors, or who pay their fees, understandably disagree with the EMH.

3. Why should I care?

   • You might not directly invest in private equity (or public equity for that matter), but your retirement fund might. You may be indirectly exposed to both.
   • Underlying this discussion is the question of how well humans can beat the market by finding and harnessing hidden value.
   • This could influence how you approach investment and opportunity.
   • This also highlights our biases, notably our bias towards symmetry; it's dead simple to actively underperform, so we believe we should be able to actively outperform.

4. Has Private Equity outperformed Public Equity?

   • Over the past decade, returns from private equity and public equity have converged.
   • Details:
     • Since 2009, US public equity returns have essentially matched returns from US buyouts (private equity) at around 15% annually.
     • While both these returns are impressive, investors expect private equity to generate alpha (outperformance) through value-creation strategies and leverage, and to compensate for private equity assets being difficult to trade (illiquidity) and value.

5. Does This Support the EMH?

   • The convergence suggests that efficiency may apply across markets over time, aligning with the strong form EMH.
   • Long-Term (Caveat): Private equity has historically outperformed, but short-term convergence prompts examination.
   • Investor Expectations: If stocks always trade at fair value, private equity’s greater risk must be justified by a greater premium.
   • Why pay handsomely for active management when you could just throw money into a passive index tracker?