Private Equity: A World of Opportunity?

The world of private equity (PE) is alluring. The Wall Street Journal regularly runs stories about the amazing amount of wealth that private equity managers have accumulated and used to buy professional sports teams or huge mansions. Our natural behavioral response is: “I want it too!”  However, PE is generally exclusive by both design and regulation and is necessarily so.

PE is more complicated and very different from buying a mutual fund or public equity. It is a large and growing business dominated by institutional investors. According to a recent report from McKinsey & Company (The Rise and Rise of Private Markets, 2018), PE funds raised a record sum of nearly $750 billion globally in 2017. And, according to a Bain & Company report (Global Private Equity Report 2018), over $440 billion was invested in over 3,000 deals globally in 2017.

However, PE is becoming more “democratized” and available to the public (e.g., non-institutional or non-ultra-high net worth investors).

Is PE right for you? How should you respond if a deal comes your way? What do you need to know?

You should start with a good understanding of what “Private Equity” is and what it entails.

1. PE firms develop specializations in particular strategies, such as buy-outs, restructurings, growth capital, etc., or in particular industries. Strategies and industries have shown cyclicality over time and have different levels of risk. You should be aware of these and know how these risk exposures fit in with your overall portfolio.

2. You generally invest as a Limited Partner – this gives you little to no voice. While that may not be so different from buying public equity, PE investments generally come with little-to-no liquidity and a long-term commitment as you enter a contractual obligation with capital call liabilities. You should be aware of the requirements and timelines.

3. They will speak to you in all sorts of financial vernacular and acronyms such as IRR, PME, TVPI, J-curve, capital calls, vintage years, hurdle rates, clawback provisions, etc., and their subscription documents can be lengthy, often up to 50 or 100 pages long! You should read these documents carefully to understand the terms and risks you are agreeing to. And, if you want some extra reassurance (which you should), have your attorney or financial adviser review the documents as well.

4. They will want to know personal information about you, such as your net worth and liquid investable assets. This is not reflective of them being nosey, it is required by law as most PE investments are limited to Qualified Purchasers or Accredited Investors (as defined by the SEC).

5. It will be hard to assess a manager’s historical performance and track the performance of your investment. Peer data isn’t as readily available as it is for publicly traded funds, and the “J-curve” return structure makes it more complicated to understand. In fact, you really won’t know the final investment returns until the fund liquidates in the distant future!

Little control, strange language, lots of legal paperwork, complicated qualification verifications, and complex performance measurements, and that’s just the start!

Given all the complexity and contractual requirements, is investing in PE worth it?

That depends on who you talk to. Theoretically, PE exploits risk factors like size and illiquidity and adds a degree of control around the business operations. Academic research (Braun, Reiner and Jenkinson, Tim and Stoff, Ingo, How Persistent is Private Equity Performance? Evidence from Deal-Level Data (December 21, 2015)) seems to indicate the following:

• PE returns are declining over time as the industry matures and increased capital from investors makes good deals scarcer and increasingly competitive.

• PE returns have historically exceeded public market returns,v but this may not be an apples-to-apples comparison as PE often uses leverage to enhance returns and historical data suffers from what the industry calls “survivorship bias.”

• Most conversations around PE returns do not include the higher level of risk PE generally involves relative to most public equity indices, such as illiquidity, leverage, business, and key man risks. Taking these into account, some academic papers argue that the risk-adjusted returns of PE firms are actually below that of public equity returns.

• Not all PE firms are created equal, as some PE firms do show some slight persistence in outperformance. Unfortunately, it is usually difficult to get access to these managers unless you have significant investable capital.

Overall, we tend to think of PE as a different way to get exposure to the equity markets while providing diversification and access to the illiquidity premium to increase expected risk-adjusted returns - if properly pursued.

So, how should you think about PE in your portfolio?

For institutions, the traditional approach is to use PE investing as an integral part of the overall portfolio. Typically, this allocation is built out across various “vintage years” and industries. Endowments and foundations may allocate 10-15% of their portfolio to PE and complete 2-4 investments per year over a 5-7 year period to achieve well-diversified exposure.

PE funds have traditionally had minimum investment sizes of $1 million or more. For most families and individuals, this would have required a minimum investment portfolio in excess of $25 million to make PE a strategic part of their allocation. However, as we noted above, the “democratization” of private investments, is opening the opportunity up to more Accredited Investors to participate at lower minimums. This is good news as a more diversified PE portfolio can be achieved at lower investment levels.

Conclusion

Private equity can be an important part of an investment strategy, is often interesting, and might even be “fun,” but you should only enter an investment with your eyes wide open on how the deal works, what is required by you today and in the future, the risks you are taking on, the timing of the cash flows, and how it fits into your overall investment plan.

While we find many investors doing “one-off” deals, it is generally better to approach PE as an integral part of your overall portfolio design leveraging the “democratization” of the PE market to build a sophisticated portfolio. This is where a good adviser can be helpful.