The public securities market is still significantly larger than the private securities market, but investments in private equity have rapidly increased over the last few decades. Because of the size of public securities markets and to protect less sophisticated investors, the public markets tend to be much more regulated than the private markets. Due to the additional scrutiny, public firms are incentivized to ensure shareholders that management is acting in their best interests and some evidence has shown that corporate governance is more effective at public firms than at private firms. Generally, public securities have much more active secondary markets where investors can easily and cheaply sell their securities at market prices.
This is not the case for private securities, which often are highly illiquid and are traded through negotiations with other investors. However, investors in the private markets expect to be compensated with higher returns for the additional limitations. Most investors gain exposure to the private markets through venture capital (start-up financing to early-stage companies), leveraged buyouts (taking companies private), or private investments in public equity (private purchases of secondary offerings by public firms). By going private, management can adopt a more long-term focus and eliminate costs related to public disclosure instead of struggling to meet quarterly targets.
Why might a pension fund decide to increase its allocation to private securities and reduce its allocation to public securities?
A. To increase the fund’s liquidity in order to pay out future short-term obligations
B. To reduce overall transaction costs and management fees
C. To increase the fund’s expected return
The correct answer is C.
A move to more investments in private securities would likely reduce the fund’s liquidity and increase transaction costs and management fees. However, most investors expect higher returns from their private security investments than public security investments.
Reading 47 LOS 47c:
Distinguish between public and private equity securities