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

Episode Summary

Executive Summary: MedFaber hosts Owen Lamont and Randy Cohen for a wide-ranging discussion on private equity, liquid private equity replication, market valuation, AI, IPO droughts, global diversification, and long-term societal risks. The conversation blends academic finance with practical investing, emphasizing how incentives, leverage, and human behavior shape markets more than neat theory suggests.

Main Topics: Private equity’s appeal and its accounting distortions (Priority: 5/5): Randy argues PE has earned strong returns and lower reported volatility, but Owen stresses that smoothing is not the same as true price discovery and can obscure risk. Liquid private equity replication (Priority: 5/5): Randy explains his long-running idea that public markets can mimic PE by combining factor tilts, industry selection, and modest leverage, creating a liquid, scalable alternative. Best ideas investing and concentration (Priority: 4/5): Randy describes research showing managers’ highest-conviction ideas outperform the rest of their portfolios, while Owen warns this does not imply concentrated portfolios are superior in practice. AI, valuations, and the IPO drought (Priority: 4/5): The hosts debate whether AI justifies current market valuations and whether a future IPO wave from firms like SpaceX, OpenAI, and Anthropic would signal a bubble. Global diversification and market flows (Priority: 4/5): They discuss Korea’s huge market move, cross-border capital flows, and the case for global diversification as geopolitical fragmentation increases. Macro uncertainty and long-term societal risks (Priority: 3/5): Randy outlines his 'five future fears'—authoritarianism, birth dearth, China, disruptive tech, and environment—while both hosts emphasize humility about forecasting. Books, ideas, and the science-fiction feel of the era (Priority: 2/5): The conversation closes with book recommendations and a broader reflection that the present moment feels historically transformative, especially around AI and education.

Key Arguments: Private equity’s reported low volatility may reflect smoothing or delayed marking rather than genuinely lower risk. PE’s excess returns can be partly explained by exposures to the same characteristics quants like: high profitability, low valuation, low risk, small size, and high payout. A liquid public-market version of PE could be highly useful because it would offer daily marks, liquidity, tax efficiency, and capacity for institutions that cannot access or scale PE. Best-ideas research shows managers’ top picks outperform their other holdings, but that does not mean investors should buy only highly concentrated managers. AI may be transformative, but its benefits may be competed away across firms, making stock-market winners hard to identify. The lack of IPOs is notable because major equity bubbles historically feature heavy issuance; a future IPO wave could be a warning sign. Global diversification matters more when countries become less correlated due to deglobalization or geopolitical fragmentation. Long-term forecasting should focus on a few major structural risks rather than many small policy debates. Human incentives and career risk often determine whether good investment ideas get adopted, not just the merits of the idea itself.

Data Points: PE outperformance: 2% to 4% per year - Randy’s estimate of private equity’s average return advantage over public markets over recent decades. Private equity reported drawdown in COVID quarter: -10% - Randy cites PE’s reported decline in Q1 2020 versus the S&P 500’s much larger drop. S&P 500 COVID quarter decline: -20% - Used as the public-market benchmark in the volatility-smoothing discussion. Typical leveraged buyout implied drawdown estimate: -25% to -28% - Randy’s rough estimate of how an LBO might have fallen given leverage during the COVID shock. Institutional meetings on liquid PE: 200+ - Randy says he has discussed the idea with more than 200 institutional investors. Leverage added in liquid PE replication: 0.3 turns - Randy argues modest leverage can help replicate PE-like returns in public markets. Expected return uplift from leverage: 2.4% to 2.5% - Randy’s example: 0.3 turns of leverage on an 8% expected return portfolio. Best ideas outperformance: About 4% per year - Randy’s paper found managers’ best ideas beat the rest of their own portfolios by roughly this amount. South Korea stock market move: About 180% over 12 months - Owen cites a near-tripling in the Korean market before a later pullback. U.S. 30-year TIPS real yield move: From about -0.5% to about 2.5% - Randy highlights a roughly 300 bps rise in real rates as a major valuation shock. Dividend yield / stock market duration approximation: About 50 - Randy uses this to illustrate how sensitive equities are to real-rate changes. Austria 100-year bond duration: Around 50 - Used as a comparison to equity duration and interest-rate sensitivity. Break-even fertility rate: 2.1 children per woman - Randy uses this as the benchmark for population replacement. South Korea fertility rate: Below 0.7 - Cited as an extreme example of the birth dearth. U.S. fertility rate: Around 1.6 - Used to show the U.S. is also below replacement level. College student schoolwork time: 15 hours per week - Owen cites survey data to argue that reduced work intensity does not necessarily cause misery.

Pivotal Quotes: "Volatility smoothing is just lying or just making up numbers." — Owen Lamont: Owen’s blunt critique of private equity valuation practices and reported volatility. "What if we develop liquid private equity?" — Randy Cohen: Randy frames his core investment idea: replicate PE exposures in public markets with liquidity. "There are two plausible possibilities." — Randy Cohen: On the impact of higher real rates and AI on market valuations, he says either markets are too high now or were too low before, or AI is far more powerful than assumed.

Implications: Investors should be skeptical of reported private-market smoothness, think globally, and watch for structural shifts like AI, deglobalization, and an eventual IPO wave. The most actionable theme is that incentives and implementation matter as much as theory.