Private markets have long outperformed public markets. Several arguments have been put forth to explain this outperformance.

One common explanation is that private companies are less efficiently priced due to information asymmetries between insiders and the market at large. Additionally, a liquidity premium exists in private markets, as investors are unable or unwilling to exit their positions as quickly as in public markets. 

Even the short-termism of public markets plays a role in the outperformance of private companies. Public companies are pressured to deliver quarterly results, while private companies can take a longer-term view. This gives private companies a significant advantage when making strategic investments, such as research and development or long-term marketing campaigns.

But a more nuanced explanation may be that active private market managers have more opportunities to generate alpha.

Alpha generation in private markets

Active management refers to actions taken by a manager that deviate from a passive strategy, such as security selection, market timing, or dynamic asset allocation. Active private market managers may also add value through their relationships and networks.

Preferential access to investments, greater control over portfolio composition, and the ability to take a longer-term view are all factors that may allow active private market managers to generate alpha. Good fund managers diligently pick winning companies and nurture those investments to ensure they’re successful.

The “fundamental law of active management,” which says an investor’s excess return equals skill times opportunity, separates the winners from the losers.

Selecting alpha-generating managers

Manager selection is comparatively more complicated in private markets due to the lack of transparency and availability of information. At the same time, it’s also far more critical in private markets due to the wider dispersion of returns. While top-quartile private equity funds produce, on average, an incredible 30% net IRR, many bottom-quartile funds lose money. The median fund’s 19% net IRR still significantly outperforms public markets, but even better returns can be achieved.

Therefore, Gridline carefully selects managers based on several quantitative and qualitative criteria that may predict outperformance. These include, but are not limited to, past performance, a conviction in the investment thesis, preferential access to investments, and the ability to add value through portfolio construction and monitoring.

To select the best managers, Gridline relies on a combination of screening tools and due diligence conducted by our team of experts. Our screening tools help to identify managers that meet our criteria, while our due diligence process allows us to assess further a manager’s skills, capabilities, and investment process.

Rather than relying solely on the built-in liquidity premium of private markets or even the “complexity premium” associated with less efficiently priced securities, Gridline looks for managers that can generate alpha through active management. We believe this is the best way to achieve superior long-term returns for our investors.

Takeaways

Private markets have delivered superior returns for several reasons. Inefficiencies in pricing and liquidity premiums are among the most commonly cited explanations.

However, more significant opportunities for alpha generation may be the most critical factor. Active private market managers have several advantages, including preferential access to investments, greater control over portfolio composition, and the ability to take a longer-term view.

But manager selection is more difficult in private markets due to the lack of transparency and availability of information. Therefore, it’s essential to carefully select managers based on many criteria that may predict outperformance.