Liquid Private Equity & Volatility Laundering (Owen Lamont & Randy Cohen) | #625

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.