The efficient market hypothesis (EMH) posits that the stock market incorporates all available information about future values due to competition, free entry, and low information and trading costs. This results in all stocks pricing at their "correct" value, as determined by future cash flows.
The EMH commonly argues that it's impossible to beat the market since all publicly available information is already reflected in stock prices. But those drivers of public market efficiency don't necessarily apply to private markets. In private markets, there are often large, inefficiently priced gaps between the current value of a company and its future potential value.
In this article, we'll discuss why private markets are less efficient than public markets, how this inefficiency creates an opportunity for alpha creation, and why selecting the right managers is essential to capturing that opportunity.
Why private markets are less efficient than public markets
There are several reasons private markets are less efficient. First, there's much less competition in private markets. Fewer investors are interested in buying stakes in privately held companies than in publicly traded companies.
Second, entry into private markets is often restricted. Investors must meet certain criteria to be eligible to invest in a particular company (such as accredited investors status or high capital minimums). This lack of competition preserves existing pricing inaccuracies.
Finally, information asymmetry is more prevalent in private markets. Private companies are not required to disclose as much information as public companies, so it's often difficult for investors to assess the true value of a private company. This leaves room for mistakes to be made in valuation.
These factors contribute to a general lack of efficiency in private markets. In other words, there are often large gaps between the current value of a company and its future potential value. This creates opportunities for skilled investors to generate alpha by identifying these mispriced assets and investing accordingly.
Inefficiency creates opportunity for alpha creation
Fund managers don't just generate alpha by taking on a liquidity premium; they also generate alpha by being more skilled than their peers at identifying mispriced assets.
In private markets, there are often large inefficiencies between the current value of a company and its future potential value. This creates opportunities for trained investment professionals to generate alpha by finding and investing in these mispriced assets.
Investors should be aware that there is a wide dispersion of returns in private markets. In other words, some fund managers will generate significant alpha while others will underperform in the market. This is why selecting fund managers carefully and diversifying your portfolio across multiple managers is important.
One way to measure a manager's skill is to look at their "track record." This can be done by calculating the alpha they've generated over a certain period. However, it's important to note that past performance is no guarantee of future results. A more comprehensive assessment should also consider the manager's investment process, team, resources, and organizational structure.
In summary, private market inefficiency creates opportunities for skilled investors to generate alpha. But those opportunities only exist if the right managers are selected. Diversification is also critical to mitigating the risk of underperforming the market.
Gridline makes it easy for individuals to find and invest in top-quartile fund managers. Our platform provides access to a curated selection of professionally managed alternative investment funds. It enables investors to diversify exposure to non-public assets with lower capital minimums, fees, and greater liquidity.