Public vs. Private Equity Securities

The public securities market is larger than the private securities market, but private equity investments have surged in recent decades. Public markets, being larger, are more heavily regulated to safeguard less experienced investors. This heightened scrutiny motivates public firms to assure shareholders of management’s alignment with their interests.

Some evidence suggests that corporate governance is more robust in public firms compared to private ones. In general, public securities have more active secondary markets, making it easier and cheaper for investors to sell their securities at market prices.

This is not the case for private securities, which are often highly illiquid and 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.

Question

Why might a pension fund decide to increase its allocation to private securities and reduce its allocation to public securities?

1. To increase the fund’s expected return.
2. To reduce overall transaction costs and management fees.
3. To increase the fund’s liquidity in order to pay out future short-term obligations.

Solution

The correct answer is A.

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.