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Scoring big with private equity funds: Though some market observers suggest these funds have matured and are less likely to bring high returns, others insist they are as remunerative as ever, provided investors choose wisely
- February 1, 2018: Vol. 5, Number 2

Scoring big with private equity funds: Though some market observers suggest these funds have matured and are less likely to bring high returns, others insist they are as remunerative as ever, provided investors choose wisely

by Joseph Dobrian

Investors who have generally associated private equity funds with real estate are finding other — perhaps unexpected — options in the category. Assets under management by private equity funds have nearly tripled in the past 17 years, to about $2.5 trillion today, according to Preqin’s 2017 Global Private Equity & Venture Capital Report, with uninvested capital estimated at $500 billion. Wealth Strategies Advisory Group estimates that private equity in general, worldwide, controls $4.5 trillion of assets; McKinsey puts the figure at $4.7 trillion.

Private equity can consist of equity and/or debt investment in companies, infrastructure, real estate and other assets. Although it is most frequently associated with real estate, it can also include healthcare technologies, mature global businesses, infrastructure and many other industries — plus an almost infinite variety of investment strategies.

Today, many private equity funds concentrate on distressed real estate portfolios, usually restricting themselves to a certain real estate type. Others invest in small-cap startup companies or in overleveraged, poorly performing larger-cap companies.

In any case, most private equity funds make money by improving the performance of the assets they acquire, which can take time. Thus, private equity funds are traditionally attractive because of their high returns. For one example, Cambridge Associates’ U.S. Private Equity Index returned 13.4 percent annually, net of fees, from 1986 through 2015, compared with an annual return of 9.9 percent for the same period from the Russell 3000 index. The former index was steadier, too, with a standard deviation of 9.4 percent in that period compared with 16.7 percent for the latter. A study recently published in the Journal of Finance found that buyout private equity funds outperformed the S&P 500 by 20 percent to 27 percent over a fund’s lifetime, and more than 3 percent annually.

However, they are illiquid. Getting out of an investment in a publicly listed company is comparatively easy. Private equity funds have much longer investment horizons, often as long as 10 years, and early exit is difficult. Thus, private equity funds have not found favor with investors who cannot tolerate illiquidity. To complicate matters further, many private equity funds follow K-1 rather than 1099 reporting, and some can have exposure to unrelated business taxable income.

Some market observers suggest that private equity funds as an investment class are maturing and, thus, less likely to bring the high returns of the past generation. Others insist the class is as remunerative as ever, although investors will have to exercise more discernment. Some private equity funds face stiffer competition from corporate investors, who typically acquire assets that are useful to their core business strategies, and who often will hold those assets indefinitely.

It appears that analyses of private equity funds as a category are of limited utility. More than ever, investors will have to analyze individual funds when deciding where to park their long-term capital.

Moreover, the criteria for choosing a private equity fund differ from those used to select, for example, a REIT. The underlying assets under management may be less important than the record of the management team — and many investment experts insist that in examining that record, consistency should outweigh the occasional brilliant coup.

Of course, private and public markets are often interdependent, and some private equity funds operate with a view to that relationship. They tend to invest in high-growth startups or distressed companies that are likely to run well ahead of the market. Often, their exit strategy consists of eventually taking those companies public and profiting by selling their stakes in the IPO.

Alan Feldman, CEO of Resource Real Estate, notes, while private equity does outperform the overall market, a handful of top managers generates most of that outperformance. A strong management team is especially important in that private equity funds tend to be countercyclical, often deploying capital irregularly and opportunistically throughout a cycle. To identify which funds are likely to be the strongest performers going forward requires skillful analysis, especially because their strategies are often complex, and they often invest in assets whose prospects are extremely difficult to evaluate.

Feldman says access to top managers, plus nontraditional assets and investment strategies, attracts many investors to private equity. Investors typically cannot hope to work with superstar managers and high-risk investments, except through this asset class.

According to PitchBook Data, a Seattle-based financial data company, about $21.5 billion went into about 1,700 venture-backed companies in the third quarter of 2017, bringing 2017’s total investment to $61.4 billion deployed across 5,948 deals to date. PitchBook points out, however, more capital is going into fewer companies, and the apparent uptick is largely fueled by large infusions of capital into “unicorn” companies such as Uber Technolgies and Airbnb, often by nontraditional investors. Venture-backed exits were slow in third quarter 2017; so was fundraising. Corporate acquisitions dropped from 166 in third quarter 2016 to 112 during the same period of 2017.

Pitchbook also reports that 963 funds have been raised since 2014, and median fund sizes in 2017 are 87 percent higher than those raised in 2015.

On Dec. 20, 2017, the London-based deVere Group, a financial advisory firm, predicted that investors on the whole should do well in 2018 due to three factors: increasing speed of global GDP growth, particularly in China and the euro zone; interest rates remaining at historic lows; and tax cuts in the United States. However, deVere cautions, three negative factors could crop up this year: a possible rise in inflation, which would weaken government bonds; a possible rise in protectionism, coming especially from the United States; and a projected slowdown of the Chinese economy, as its government encourages a focus on services and household consumption.

Vince Annable, president of Wealth Strategies Advisory Group, notes investing in private equity funds is especially attractive in that it affords exposure to private operating companies, which provide diversification from publicly traded stocks, bonds and mutual funds, as well as lower volatility compared with traditional markets. Private companies have historically outperformed other asset classes over various time periods, he points out, and in many cases the general partners of private equity funds get no performance incentive unless investors reach a predetermined preferred rate of return. What’s more, investors earn an illiquidity premium for investing in nonpublic private equity funds.

In recent years, private equity funds of funds have made private equity investments accessible to smaller investors who might not care to meet the high monetary barriers typically set by private equity funds; however, these funds’ fees can be high. Often, the manager and subadviser will both charge a management fee. These funds do not provide access to the private marketplace itself, due to liquidity constraints.

Private equity funds’ chief risks lie in the typical multiyear hold period, which could be extended should the market not be favorable for a liquidity event. The sector as a whole has enough variety, though, to allow investors to seek and find their comfortable level of risk. For example, a venture capital fund might invest in innovative startup companies. Others might focus on growth-stage investments, targeting companies as they enter the mature phase of their life cycles and are positioned to deliver strong performance and dividends. Others may involve private equity investments in varying real estate opportunities. Annable advises examining the following factors when considering an individual fund:

  • Current and sustainable yield. Companies that already generate returns, and show signs of being able to continue to do so going forward, have the best likelihood of delivering distributions over the long term.
  • Proven operating partners/management team. If the operating partners or management team that helped build a growth-stage company to its present state will remain with the firm, and retain a minority ownership stake, the company is probably on track to meeting its goals for expansion and profitability.
  • High barriers to entry. An income-producing company that operates in an industry where new competitors cannot easily emerge has a much lower risk of disruption.
  • Recession-resiliency. A growth-stage company that operates in an industry that is generally immune to economic downturns is likely to remain profitable regardless of market conditions.

“You need a clear understanding of a particular private equity fund’s investment strategy, to balance the fund’s objectives with an investor’s risk tolerance,” Annable says. “Consider the targeted hold period of the investment. Will a liquidation happen all at once or in phases? Will regular cash distributions be declared? What are the characteristics of the industries the fund will invest in?”

Investors should then ask about any restrictions placed on the fund in terms of how much or what types of companies can be invested in, and whether the fund will purchase entire companies, or simply take a majority or minority stake. Will the fund manager provide managerial assistance?

Potential investors should examine the management team’s track record and reliability, its transparency, its financial metrics, its fee structure. How is management incentivized to perform in the best interest of investors?

Mark Weisdorf, senior adviser at Star Mountain Capital, explains that the returns on private equity funds are often higher than other investments because these funds pursue properties that have not been optimized, properties that are a little tired, or redevelopment opportunities. Publicly listed funds tend to prefer fully leased properties that promise a steady yield, albeit a lower total return. When choosing an opportunistic or development-oriented fund, it is vital to know the manager’s track record, especially because your investment might be locked in for 10 years.

“Be mindful of what kind of real estate you invest in and where it is in the cycle,” he urges. “Attractive alternatives to the industrial, commercial, residential and office sectors include nursing homes, student housing, military housing, subsidized municipal housing and so on. These sectors are idiosyncratic, and in each subsector some managers are better than others.”

Weisdorf advises investors to assess more than the expertise and background of a fund’s management team, but how well they will work together as a team. If they have weathered more than one investment cycle, and have a clear expertise in a subsector and region, they may merit attention. The economic cycle is an important issue. If the economy is weakening or tepid, a fund that operates in gateway cities might be indicated. In the early days of strengthening economy, secondary cities could generate higher returns.

The private equity market, Weisdorf concludes — be it in real estate, infrastructure, leveraged buyouts or technology — has been growing faster than the listed sector, and institutional investors, with their longer investment horizons, are driving that growth. As a result, he says, more managers have been working to attract high-net-worth investors to the private equity markets — through creative structures, including listed MLPs and trusts, that invest in private equity.

John Guthery, managing director at Provasi Capital Partners, says the number of companies choosing to list on major exchanges has declined considerably in recent years, and the private market is significantly greater than the public market. Moreover, strategies such as buyouts and distressed investing are hard to pursue in public markets.

“Private markets also allow for additional opportunity sets,” Guthery adds. “This can include a greater degree of active management in a turn-around scenario — sometimes a more patient strategy than quarterly earnings allow for in the public markets — and a more active use of leverage than is often accepted in the public market.”

He cautions that private equity is not always as transparent as public equity. Therefore, it is important to work with a fund or manager that takes a proactive approach to oversight and risk control. Many funds accept higher risk in exchange for potential high returns and are not appropriate for all investors. It is important for the investor to understand how much risk a fund or manager is taking. This can vary dramatically from one fund to another.

Guthery, like his colleagues, observes that past performance is not a reliable predictor of future performance with private equity. Investors should look for consistent performance over a long term. The best deals tend to go to the best managers, those who understand private equity strategies and risks, as well as how they differ from those of public entities.

Joseph Dobrian (jdobrian@aol.com) is a freelance writer based in Iowa City.

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