Superior Outcomes Through Mechanism Design in Private Markets

By: Gridline Team | Published: 09/12/2023
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3 minutes

The allure of private equity lies in its potential for superior returns, which hasn’t escaped individual investors’ notice. Over the past quarter-century, private equity has yielded an impressive 14% return globally, doubling the 7% offered by the MSCI World Index.

Nevertheless, in contrast to public markets, success in private markets is far from a given, owing to the challenge of picking the right investments and the relative scarcity of data.

Mechanism design is employed to safeguard returns on private investments, including but not limited to governance, project finance, return protection, and meticulous control mechanisms.

Mechanism Design: The Secret Sauce

Mechanism design, often hailed as ‘reverse game theory,’ has its roots firmly planted in the arena of economic theory. Championed by Leonid Hurwicz, the 2007 Nobel Laureate in Economics, it revolves around creating a strategic environment or ‘game’ that induces participants to behave in a way that leads to a desired outcome.

Hurwicz and his collaborators, Eric Maskin and Roger Myerson, also Nobel Laureates, made significant contributions to developing and applying this theory. Their work has provided a theoretical basis for understanding how private markets function.

As per Hurwicz’s theory, mechanism design attempts to construct systems that provide the right incentives to encourage the most beneficial behavior from each participant. It’s like designing a game where the rules are laid out so that the players, acting in their own self-interest, will bring about an optimal outcome for everyone involved.

In private markets, the mechanism design theory finds significant application. Consider private equity, for example, where the relationship between general partners (GPs) and limited partners (LPs) is a prime case of a ‘game.’ The GPs, who manage the investments, and the LPs, who provide the capital, have incentives and information. The mechanisms used, such as carried interest and hurdle rates, align the interests of the GPs and LPs, leading to mutually beneficial outcomes.

Fortunately, private market conventions have evolved to align interests.  For example, fees over the first several years of an investment partnership are commonly calculated on committed capital rather than invested capital, reducing the incentive for GPs to quickly invest in substandard deals to start receiving fee income. Similarly, carried interest (commonly called carry) often represents 20% of the proceeds from any investment sale, but that is frequently only available to GPs if the investment being sold has compounded in value above 8% annually. This ensures that GPs are not being rewarded for holding a mediocre investment for several years, nor are they receiving carry based on their own estimates of portfolio value.

Statistical Evidence: Private Markets Outperforming Public Markets

A deep dive into the performance of private markets over the past two decades unveils a consistent trend of outperformance compared to their public counterparts. The Hamilton Lane 2022 market overview report provides compelling evidence of this. It reveals that every year in the past twenty, buyout returns in private markets have surpassed the MSCI World PME by a staggering average of 1,000 basis points.

Similarly, private credit has not lagged, having consistently exceeded the performance of leveraged loans annually by an impressive 625 basis points over the same period. This long-standing trend demonstrates the potential for superior returns in the private market sector.

During 2022, private markets displayed remarkable resilience, surpassing public strategies across all sectors. Illustratively, buyout returns in private markets outpaced the S&P 500 by almost 2,050 basis points. Furthermore, the private sector’s infrastructure and real estate exceeded the FTSE All Equity REITs Index by a considerable margin, over 3,400 basis points, to be precise.

A recent survey showed that 86% of participants believe that the trend of private markets outperforming public markets is likely to continue. This sentiment points to the growing confidence in private markets and their potential for higher returns.

Moreover, historical data indicates that private equity provides superior risk-adjusted returns and tends to outperform public equity by a more significant margin, especially during periods of economic distress. This pattern suggests that the mechanisms at play within private markets can effectively contribute to higher returns.

With Gridline, private market investing becomes more straightforward and more accessible. We provide the tools to navigate these markets effectively, harnessing the power of diversified, professionally managed funds.

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