Wimpy and private equity - Investors can avoid the worst issues through replication alternatives

Wimpy's motto is, "I will gladly pay you Tuesday for a hamburger today". The concept of long lock-ups in private equity investments without full disclosure of the investments or effective valuation follows the Wimpy motto. Pay us today with cash which will be invested over time with a management fee every year and a 20% carry that is paid when you are given your cash back. There is clear investment uncertainty and illiquidity that requires extra compensation than what would be expected from any public investment. 

Many studies have shown the strong returns from private equity that make it an attractive investment. Still, private equity requires an inherent optimism with a strong commitment of time. There is also evidence that private equity returns can be replicated in more liquid public markets. Private equity may not be as unique as marketed.

Private equity replication requires three components, equities that match the underlying PE investments, leverage, and long-term accounting. See "Replicating Private Equity and Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting" by Erik Stafford of the Harvard Business School for a good study of the differences. See L’Her, Jean-François, Rossita Stoyanova, Kathryn Shaw, William Scott, and Charissa Lai. 2016. “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market” Financial Analysts Journal 2016, vol. 72, no. 4 (July/August): 36-48 for another comparison between public and private funds. In both of these cases, looking at some simple criteria such as small cap and value provides the basis for liquid replication of private funds.

Private equity investments focus not on large cap firms but smaller firms with low EBITDA and some leverage. The problem with replication is that the valuation process will show a markedly more volatile investment than what is received with a private equity fund. While valuations will be similar to a public fund, there will be greater smoothing and possible upward bias in private equity valuations. The accounting differences matter. 

Nevertheless, investors can have greater control over their investments and still reach the same return potential at lower costs through replication strategies. However, to realize these gains requires the investor to commit to a long-term investment and accept variation in valuations that will suggest greater risk than a private equity alternative.