Virtual private equity a step closer to reality

A lot has been written over the past few years about hedge fund/private equity “hybrids” where a so-called “side-pocket” is created to hold a particularly illiquid investment.  But while these funds may indeed contain both asset classes, they are long and short in public equities and long-only in private equities.  In other words, it is difficult to actually hedge private equity.

Of course, you could always short comparable public equities (or even an index) against a long position in private equity.  In fact, given the high correlation between private equity and public equity, that might not be a bad idea.  There has been some research showing that a leveraged public equity position could actually trump private equity on a risk adjusted basis (see related posting).

But insofar as private equity has its own return characteristics that are uncorrelated with public equity beta, it can’t truly be hedged.

This may be changing soon.  State Street is reportedly working on a “private equity replication” model that will complement its existing hedge fund replication model (see recent posting on that one).

Eric Brandhorst, head of the research and structured products group at SSgA told Thomson last week:

“We are looking into private equity indexing opportunities. Our custody business has generated a product which is an index of private equity returns – we built a benchmarking tool for investors who want to understand how the universe of private equity investors is doing. So we are working with those returns to try and understand from an index perspective what those returns look like.

“We stand ready to manage through an investment in publicly traded investments and we are researching the returns based analysis.”

Such a product would be interesting for at least two reasons.  One, it would allow a more liquid and transparent way invest in private equity.  And two, it could enable a short position in “private equity beta” (whatever it is, if it indeed exists).  As a result, investors could potentially short-out private equity exposure to better isolate the alpha produced by their PE managers.

This is actually a product feature commonly cited by suppliers of hedge fund replication products.  By shorting-out convertible arb beta from a convertible arb fund, for example, one could potentially isolate the true alpha of their manager they argue.

It remains to be seen if we’ll be able to add hedge fund replica to a PE replica in order to create a hybrid fund replica. How about a replica of a side-pocket?  It’s like a virtual reality investment portfolio – like the asset management version of the website “Second Life” where users create replicas of themselves – only better looking – and fly around a virtual landscape going to virtual dance clubs and hooking up with other replicas.

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