The allure of the unlisted: should active owners have faith in private equity?

The Ontario Teachers' Pension Plan (OTPP) is one of Canada’s largest asset owners with over $247 billion in net assets. As an active owner with ambitious emissions reduction targets, one might expect the OTPP asset mix to reflect a mighty embrace of listed equity – where the battles over engagement, stewardship and disclosures are being fought.

Yet, at last count, about 24% of OTPP’s asset mix is in private equity – stakes in unlisted companies. OTPP is not alone. 15% of the New York State Common Retirement Fund’s capital is in private equity holdings. Tamasek Holdings, a Singaporean asset owner has an unlisted portfolio that represents 53% of its capital allocation. Tamasek too, is an active owner chasing a carbon neutrality goal.

At a time when active ownership is the norm rather than the exception, asset owners are increasingly drawn to the unlisted.

A new discussion note from Norges Bank Investment Management has revealed that capital allocation to private equity funds is at record highs. $7 trillion – is the estimate of assets under private equity management.

Peak demand

The onset of the private equity allocation was in some ways, predictable. For over a decade, a low interest rate environment had forced asset owners to look outside the traditional allocation box. Lower returns from sovereign debt prompted a willingness to accept risks and illiquidity in the hopes of meeting return expectations.

Over time, private equity funds became a point of intense debate and cautious optimism. In a 2021 op-ed, Babloo Sarin, head of asset owners for Asia-Pacific at State Street - the world’s fourth-largest asset manager - referred to private equity as “a rising star in a multi-asset universe”.

Private equity funds are commonly structured as a partnership between one or more institutional players and a private equity firm. The investors, the limited partners, gain access to an attractive investment menu –leveraged buyouts, growth equity and venture capital.

What makes this menu relevant to active owners is its sectoral flavor. Technology and infrastructure, both of which are key pieces of the transition puzzle, tend to account for a large share of private equity deals. Renewable energy production, batteries, power storage and transmission are examples of the centrality of tech-infrastructure assets in emissions reduction.

These funds typically involve lower liquidity and higher costs, but their performance allows cautious optimism to creep in. “We find private equity buyouts have meaningfully outperformed public equities by 3 to 4 percentage points annually, on average.”, Norges Bank’s discussion note says.

Principal – Agent Problems

Despite the rapid growth of the sector, optimism remains cautious. Active ownership in private equity is less than straightforward, fraught with risk and arguably devoid of regulatory cover.

One such complexity is the principal-agent problem, a far from unfamiliar territory to the asset management industry. Managers typically invest capital that is not their own. In private equity markets too, this reality remains.

In a private equity fund, investors are limited partners (LPs). The private equity manager is the registered general partner (GP). LPs exercise ownership (principal while the private equity firm (agent) manages the fund’s day-to-day affairs.

The problem, economic theory predicts, is that while the agent is expected to act in the best interests of the principal – the agent’s incentives often differ.

In this case, the private equity firm’s strongest incentive is management fees, more so than performance. Implying an incentive for a private equity firm to focus on fund size rather than any metric of expected performance including portfolio emissions reduction.

The crux of the issue is the partnership agreement that structures the asset owner’s adventures in private equity. The agreement is a negotiated outcome and reflects relative bargaining power. If demand for private equity is high, bargaining power of the agent overshadows that of the principal.

“In theory, the terms of the limited partnership agreement which governs the relationship between the investor and the general partner, can be used to minimise the potential for agency conflicts. In practice, however, completely investor-friendly agreements are difficult to achieve”, the discussion note reads.

Going Private, Going Dark.

In addition to fund management incentives, there is also the issue of regulating private markets. Unlisted companies face lesser regulatory pressure than their listed peers to disclose the details of their emissions – information that active ownership depends on.

The discussion note from Norges Bank includes a reminder: “As private markets disclose less than public markets in general, it is important that prospective investors examine whether disclosures are sufficient to manage their ESG objectives and reporting requirements”.

That being said, all is not dark. Even though disclosures are voluntary, they seem to be on the rise. Recent research by economists at the London Business School seem to suggest that private equity firms react positively to investor demand for disclosures, even in the absence of regulatory discipline.

Additionally, some private equity firms are listed. Blackstone, the American alternative manager, for instance, is listed on the New York Stock Exchange. The US Securities and Exchange Commission’s (SEC) proposed climate disclosure rules could effectively apply to such firms and their financed emissions (portfolio companies). 

Private equity’s role in channelling capital into transition assets is hard to ignore. A decade-old aura of investor confidence in unlisted equity will push the complexities of capital allocation in private markets into the spotlight. Complexities that are conditioned by known unknowns and the familiar struggles of active ownership.