How Game Theory Supports the Case for Alternative Investments

How Game Theory Supports the Case for Alternative Investments
By: Gridline Team | Published: 06/15/2023
Est. Reading Time:
3 minutes

In recent years, private markets have attracted significant interest from investors seeking to diversify their portfolios and enhance their returns. The rise of private equity, venture capital, and other alternative investment strategies has highlighted the potential advantages of private market investing. Let’s explore the "game theory" perspective on private markets, illustrating how factors such as information asymmetry, reduced competition, aligned incentives, and long-term focus reinforce the advantage of private market investing with better returns than those offered by public markets.

Information asymmetry

In private markets, there is often less information available to the general public than in public markets. In fact, the annualized return for PE was 11.0% over a 21-year period, compared to 6.9% for public stocks over the same time, thanks to informational advantages.

This information asymmetry creates opportunities for investors with superior knowledge, expertise, and access to information. By leveraging their informational advantage, these investors can identify undervalued assets and achieve higher returns than their counterparts in public markets.

Reduced competition

Public markets, with their accessibility and liquidity, have a broad appeal, attracting millions of investors. In 2022, 58% of American adults invested in the stock market, amounting to approximately 150 million people. This immense level of participation can result in a highly competitive environment where information is quickly assimilated and asset prices are driven toward their true value, leaving fewer opportunities for investors to capitalize on inefficiencies.

Moreover, the number of public companies has been shrinking. In recent years, there have been around 4,000 companies listed on public exchanges in the United States. Further, private markets have a significantly smaller investor base. In 2016, there were an estimated 12 million accredited investor households in the United States: A small fraction of the 150 million American stock market investors.

Adding to this dynamic is a vastly larger number of private companies. There are approximately half a million private companies in the United States. In 2020, there were around 4,500 private equity firms in the United States, backing approximately 16,000 private companies. This landscape of far more companies and fewer competing investors in private markets presents a fertile ground for identifying and investing in undervalued assets.

A crucial factor contributing to this abundance of private companies is the decline in the number of IPOs. Companies increasingly opt to stay private for longer periods, allowing them to avoid the pressures and regulatory scrutiny associated with going public. This trend has resulted in an expanding pool of private companies ripe for investment, presenting many opportunities for discerning investors.

Principal-agent problem

In public markets, the interests of investors (principals) and company management (agents) may not always be aligned. This misalignment can result in agency costs that reduce overall returns.

In private markets, investors often have more direct influence and control over the companies they invest in, which can help better align interests and improve returns.

Further, public markets are often characterized by short-termism, with investors and companies focusing on quarterly results and stock price fluctuations. Private markets tend to have a longer investment horizon, allowing for more strategic decision-making and potentially higher long-term returns.

The bottom line

In recent years, private markets have attracted significant interest from investors seeking to diversify their portfolios and enhance their returns. Game theory provides valuable insights into the dynamics of private markets, illustrating how factors such as information asymmetry, reduced competition, aligned incentives, and long-term focus contribute to better returns than those offered by public markets.

Gridline, a digital wealth platform, aims to provide individual investors and their advisors with access to professionally managed alternative investment funds in private markets. Through its institutional-grade process for identifying and evaluating top-performing fund managers, Gridline offers a curated selection of funds that enable diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.

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