Liquid Private Equity & Volatility Laundering (Owen Lamont & Randy Cohen) | #625
Owen Lamont and Randy Cohen discuss the problems with private equity's volatility smoothing practices and present the concept of 'liquid private equity' - using public markets to replicate private equity strategies through factor investing. They also explore their 'best ideas' research showing that managers' top-conviction picks significantly outperform.
Summary
Owen Lamont from Acadian Asset Management and Randy Cohen from Harvard Business School engage in a wide-ranging discussion covering multiple investment topics. They begin by examining private equity's claimed benefits - diversification and superior returns with lower volatility - but highlight the fundamental problem of 'volatility laundering' where PE firms report artificially smoothed returns because they control their own valuations. During COVID's first quarter, while the S&P 500 dropped 20%, leveraged PE deals reported only 10% declines despite having higher leverage that should have amplified losses.
The guests present their solution: liquid private equity that replicates PE strategies in public markets. They identify that successful LBO targets share characteristics that align perfectly with the five Fama-French factors: high profitability (to service debt), low multiples (to make deals feasible), low risk (to secure financing), smaller size, and high payout ratios. By systematically targeting these factors plus industry selection expertise and modest leverage (0.3 turns), they argue investors can capture PE-like returns while maintaining liquidity and transparency.
Randy discusses his influential 'best ideas' research, which used Black-Litterman optimization to reverse-engineer managers' highest conviction picks from portfolio weights. The study found that managers' top ideas outperformed their other holdings by about 4% annually, validated in out-of-sample testing by Barclays. However, Owen cautions against misinterpreting this as evidence that concentrated managers are superior - the research examined top picks within diversified portfolios, not concentrated strategies themselves.
The conversation shifts to current market dynamics, including the puzzling lack of IPOs despite high valuations and massive corporate cash flows. They note this IPO drought resembles the 1970s or 1930s, contrasting sharply with typical bubble periods. They explore whether AI justifies current valuations, with Randy calculating that the 300 basis point rise in real interest rates since 2021 should theoretically have caused a 75% market decline based on duration analysis, yet markets have risen 40%.
The discussion concludes with broader themes including global diversification benefits as the world potentially deglobalizes, demographic challenges from declining birth rates, and Randy's 'five future fears' framework covering authoritarianism, birth dearth, China relations, disruptive technologies, and environmental issues. Throughout, they emphasize the importance of intellectual humility given the complexity and unpredictability of markets and economic systems.
About this episode
Today’s guests are Owen Lamont, a Portfolio Manager at Acadian Asset Management, and Randy Cohen, a finance and entrepreneurship professor at Harvard Business School and co-founder of PEO Partners, which is a leader in the emerging liquid Private Equity alternatives space. In today’s episode, Owen Lamont and Randy Cohen begin with a deep dive into private equity, how to model it in public markets, and why investors are searching for liquid ways to access private-market-like returns. They challenge common views on concentration, market valuations, and explain how investors should think about bubbles and technological change. They also discuss whether the US stock market is Koreafying and the long-term forces that could shape the investing landscape. (0:00) Starts (0:34) Welcome Owen and Randy (5:14) Private equity overview (9:20) Liquid private equity (20:05) The US stock market is Koreafying (24:29) The IPO landscape (36:03) CAPE Ratio and AI (44:45) Best ideas investing (58:44) Deglobalization increases the benefits of diversification (1:00:36) Randy's five future fears (1:11:09) Book recommendations ----- Follow Meb on X, LinkedIn and YouTube For detailed show notes, click here To learn more about our funds and follow us, subscribe to our mailing list or visit us at cambriainvestments.com ----- Follow The Idea Farm: X | LinkedIn | Instagram | TikTok ----- Interested in sponsoring the show? Email us at [email protected] ----- Past guests include Ed Thorp, Richard Thaler, Jeremy Grantham, Joel Greenblatt, Campbell Harvey, Ivy Zelman, Kathryn Kaminski, Jason Calacanis, Whitney Baker, Aswath Damodaran, Howard Marks, Tom Barton, and many more. ----- Meb's invested in some awesome startups that have passed along discounts to our listeners. Check them out here! ----- Editing and post-production work for this episode was provided by The Podcast Consultant (https://thepodcastconsultant.com). Learn more about your ad choices. Visit megaphone.fm/adchoices
Key Insights
- Private equity's reported low volatility is achieved through 'volatility laundering' - firms control their own valuations rather than accepting market prices, making reported volatility figures meaningless
- Successful LBO targets naturally align with the five Fama-French factors: high profitability, low multiples, low risk, smaller size, and high payout ratios
- Liquid private equity can replicate PE performance by systematically targeting these factors plus industry expertise and modest leverage of 0.3 turns while maintaining liquidity
- Managers' highest conviction picks outperform their other holdings by approximately 4% annually, but this doesn't mean concentrated managers are superior to diversified ones
- The current IPO drought resembles bear market conditions of the 1970s or 1930s despite high market valuations, creating a puzzling contradiction
- The 300 basis point rise in real interest rates since 2021 should theoretically have caused a 75% market decline based on duration analysis, yet markets rose 40%
- Either AI is expected to increase corporate cash flows by 3-4x to justify current valuations, or markets are making significant pricing errors regarding interest rate sensitivity
- CEOs historically act as contrarians with their own stock, timing issuance and buybacks effectively, making the current lack of equity issuance despite high prices particularly puzzling
- As the world potentially deglobalizes, the benefits of global portfolio diversification should increase as country correlations decline
- Corporate specialization in investment management shows empirical benefits, separate from the question of portfolio concentration
- The current market environment may justify valuations reaching Japan 1989 levels (CAPE of 60) if the AI revolution matches the scale of electricity adoption
- Institutional resistance to new investment approaches often stems from career risk considerations rather than the merit of the strategies themselves
Topics
Transcript
Welcome to the MedFaber show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here. MedFaber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria's funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambrianvestments.com. Today's show is sponsored by Cambria. Do you hold legacy investment positions with significant gains? What if you could transition…
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