The past 10 years have presented investors with highly unusual economic and financial conditions. In the wake of the 2007 global financial crisis and subsequent Great Recession, major economies settled into a pattern of sluggish growth, stagnant wages and rock-bottom interest rates. This combination did not offer investors a wide range of options to generate returns.
Ultra-low interest rates pulled down the risk-free rate of return and, in search of yield, capital flooded into various assets, including equities, high-yield bonds and others. This capital superabundance pushed up asset prices and drove down yields. At the same time, sluggish economic and wage growth meant there were few potential sources of organic market growth.
The consequences of these dynamics are on display in the current performance of the S&P 500 Index, which is trading at near record price and valuation highs while offering a dividend yield of less than 2 percent, well below its historical average of more than 3 percent. With such frothy markets, investors in search of meaningful alpha are finding few options in the traditional asset landscape.
As a result, large institutional investors have increasingly turned to alternative assets, including real assets such as real estate, infrastructure, commodities and energy, and to alternative investment strategies, such as private equity, to achieve their investment objectives. Private equity (PE) offers the promise of higher returns, enhanced diversification, lower volatility and access to otherwise inaccessible assets. However, despite these potential benefits, individual investors have been slow to follow suit.
BENEFITS OF PRIVATE EQUITY
PE is a large, diverse and growing asset class. According to Prequin, global PE assets under management are about $2.5 trillion, and the industry raised almost $350 billion of new capital in 2016.
Returns: The most important benefit PE offers is the potential for market-beating returns. Respected academic studies have estimated that PE outperforms public equity markets by 3 percent to 4.5 percent a year, a significant premium. The most recent of these studies published in the Journal of Finance found that buyout PE funds outperformed the S&P 500 by 20 percent to 27 percent over a fund’s lifetime, and more than 3 percent annually.
This outperformance is typically generated through several mechanisms. First, as Bain notes in its annual global private equity report, PE funds tend to invest in high-growth startups or distressed companies, which offer the potential for growth that exceeds that of the market. Second, PE firms frequently invest in companies that exploit new technologies or invest in high-growth real assets such as distressed real estate or new energy sources. Such assets may deliver market-beating growth. Finally, many PE firms seek to take public the companies in which they invest, potentially generating outsize capital returns upon the sale of their stakes in initial public offerings.
However, while PE delivers meaningful outperformance in aggregate, it is important to note that academic studies of PE returns have unanimously reported the majority of that outperformance is generated by top managers. While the top quartile of funds delivers significant returns, the bottom quartile typically performs worse than the markets. In the pursuit of returns, investing with the right PE manager is vital.
Diversification: Another valuable PE benefit is portfolio diversification. PE is intended to be a counter-cyclical, long-term investment, with stakes typically held for a period of five to 10 years and with limited secondary markets. This structure enables a PE fund to deploy capital through the cycle and to focus management time and effort on improving the performance of the companies it invests in.
The result is a low correlation between PE returns, including capital distributions that totaled over $180 billion in 2016, and market returns. Uncorrelated assets are the key to portfolio diversification, and thus a PE allocation has the potential to enhance diversification for investors.
Low volatility: Related to its diversification potential, PE seeks to deliver lower volatility than the markets. The long-term nature of PE investments, together with PE funds’ preference for carefully timed liquidation events, may serve to smooth returns and lower volatility. Cambridge Associates data indicates that between 2004 and 2014, the S&P 500’s volatility was 15.8 percent, while the volatility of the Cambridge Associates U.S. Private Equity Index was 9.9 percent.
Access: A less widely discussed but still important benefit that PE offers is access to top managers and nontraditional assets and investment strategies. Many of the world’s most sophisticated and experienced investment managers work in private equity, attracted by the remuneration and professional challenges PE funds offer. Only by investing in PE can individuals access these managers’ expertise.
Similarly, PE funds frequently invest in companies working in innovative technologies, such as biotechnology and other specialized areas. It is typically not possible for investors to gain exposure to these high-risk, high-reward sectors, except through PE. Additionally, PE funds pursue strategies such as leveraged buyouts that are not pursued by other investment funds. Access to these unique strategies is restricted to PE investors.
BARRIERS TO ENTRY
Despite the range of attractive benefits that PE offers, the individual investor’s uptake has been slow. There are several reasons for this.
Inaccessibility: This is perhaps the primary reason that individual investors do not allocate to PE. Most PE funds are structured as limited partnerships and investors in LPs must be accredited. This means they must have a net worth that exceeds $1 million (excluding primary residence) and income of more than $200,000 for an individual or $300,000 for a married couple for the past two years. Furthermore, private equity LPs typically have investment minimums in the seven-figure range, which are frequently out of reach for even accredited investors.
Illiquidity: PE investors commit to the long term. The typical LP agreement lasts for 10 years and there are usually only limited opportunities for early exit from these agreements. In addition, there are risks to traditional PE exit strategies such as IPOs. Securities legislation requires that certain individuals who hold stakes in private companies that go public retain their shares for a period of up to one year after the IPO. This exposes PE investors to a degree of market risk when exiting their positions. Restrictions such as these can potentially extend the period of investment illiquidity as fund managers attempt to time exits favorably.
For investors, the prospect of a prolonged period of illiquidity can be daunting. Investors typically value liquidity and are averse to liquidity risk. However, the argument in favor of allocating a portion of a portfolio to illiquid assets is compelling. Credit Suisse points out that illiquid assets typically offer investors a so-called illiquidity premium to compensate them for the liquidity risk they incur. Essentially, investors pay less for a given cash flow from an illiquid asset than they would for the same cash flow from a liquid asset. This has the potential to drive benchmark-beating returns for investors.
Fees: Like hedge funds, PE funds typically charge significant fees. Historically, the industry norm has been “2 and 20” — a 2 percent management fee and a 20 percent performance fee levied on profits from investments. On a $2 billion fund, that translates into fees of $40 million for the general partner (GP) or fund manager before any profits are generated.
The prospect of these high fees can be a deterrent, particularly for those accustomed to the much lower fees on traditional investment products. However, fees need not undermine the returns an investor in PE can generate. First, the 20 percent performance fee is levied only if the fund is profitable, permitting investors to benefit from outperformance and incentivizing managers to generate returns. Second, Bain reports that there has been increasing downward pressure on PE fees as institutions focus more on net returns. Investors may benefit from this trend by investing in a growing pool of lower-fee PE options.
Complexity: A final source of investor hesitation is the inherent complexity of the asset class. As noted, PE outperformance is primarily driven by top-performing funds, and identifying which funds are likely to deliver top performance may demand a sophisticated set of analytical skills. Understanding the complex strategies PE funds pursue and the nontraditional companies they invest in can pose a challenge. Few investors are equipped to properly evaluate the long-term potential of a biotech startup or a distressed oil and gas exploration company.
OVERCOMING ROADBLOCKS
The obstacles to PE investment are not insurmountable. In fact, investors have options for including PE exposure in their portfolios that have the potential to allay their concerns.
Accredited investors can invest in funds that invest in PE funds. These PE funds of funds typically have lower investment minimums that range from $100,000 to $250,000. Funds of funds spread their investment risk over a pool of managers, so they may be better able to capture the outperformance generated by top managers. However, while they are more accessible and offer investors the guidance of a qualified fund manager, such funds add an additional layer of fees and may be illiquid.
Another sometimes-cited option is to invest in listed PE firms. There are several exchange-traded funds (ETFs) that invest primarily in the equity of listed PE firms, seeking to benefit from the performance of the underlying PE investments these companies make. However, an investment in a PE management firm is not equivalent to an investment in PE itself. Historically such ETFs have underperformed benchmark indices such as the S&P 500 and experienced relatively high volatility. Thus, while they offer liquidity and access, they have failed to deliver the outperformance that a true PE allocation may provide.
A third option is to invest in funds that include direct PE investments within their diversified portfolios. There are a growing number of alternative investment fund structures, such as closed-end interval funds, that enable fund managers to pursue direct PE investments within an accessible fund wrapper. Such funds offer lower investment minimums and reduced suitability standards, and seek to deliver the returns and low volatility associated with investments in institutional private equity. They offer investors the benefit of professional portfolio management expertise in selecting PE assets, as well as limited liquidity. By combining illiquid PE investments with other, more-liquid options, such funds are able to support periodic share redemptions, typically 5 percent of outstanding shares every quarter. These funds may offer investors the best of both worlds.
There is a growing pool of possibilities for investors seeking exposure to PE. New structures and options seek to overcome traditional barriers to PE investment, such as access and liquidity, while offering the benefits that institutional investors in PE have historically enjoyed.
Alan Feldman is CEO of Resource, the marketing name for Resource America Inc. and its adviser subsidiaries.