The old adage claims there are two taboo subjects people should never discuss over the dinner table: religion and politics. As the holidays approach, I fear private equity needs to be added to that list because it has become this year’s hot potato — now represented by well over $4 trillion in investable assets, and about 40 percent of that in dry powder. Why the sensitivity?
The endowment model turned 50 years old this past year. While David Swensen popularized the concept of broader asset class diversification at Yale, it was the Ford Foundation in the late 1960s that first dabbled in expanding outside of publicly traded securities. Since then, we have seen a significant rise in allocations in institutional portfolios of all sizes as investment professionals pursue more persistent and reliable investment outcomes for their clients. The average pension fund has nearly 30 percent devoted to alternatives, and more permanent capital such as foundations, endowments, and family offices are even higher than that in some cases. Wealth management firms with high-net-worth clients devote about 12 percent to alternatives, and that figure is expected to rise considerably as platforms, wrappers and education proliferate. There is a growing chorus calling for more democratized access to the general public in the halls of the regulators, and the SEC began that process with the expansion of the accredited investor rule in August.
Underlying this hyper-diversification has been a 25 year-long tectonic shift away from public market to private market capital formation. Since the public company peak of 1996, companies are choosing to stay private longer as the benefits of IPOs are now largely satisfied in the private markets. Continuing to pretend that public equity and debt markets alone are a fair proxy for the global economy is now foolhardy.
Constructing a portfolio that provides income, inflation protection, capital preservation and uncorrelated cash flows is foundational for every long-term investor. Alternative investments play a complementary role to publicly traded securities in achieving this diversification with the additional benefits of downside protection and less volatility. The tension arises, however, due to uncomfortably high costs, opaque management fees, dislocated alignment of interest in one-sided carried interest incentives, a lack of a uniform performance measurement, and compromised fiduciary standards in LP/GP agreements. The industry needs reform and progression from adolescence to responsible citizenship.
But it’s a subject we have to debate respectfully and objectively. It’s complex and requires nuance, maturity and active listening skills. I’ve been perturbed and disappointed with the rhetoric we’ve seen in the capital markets, the media, and from the public square around private equity. Two polarized tribes have arisen. Private equity is either a savior to low interest rates and over-bought public equities in order to close pension funding gaps and at-risk retirement goals. Or, it is a loose collection of modern robber barons bent on stripping assets and jobs and preying on humanity.
Neither of these hyperbole-loaded narratives is correct. One characterizes the industry as nothing more than a casino trip for managers looking for the next bastion of alpha, and the other is fear-mongering click bait. Our clients deserve better than this. We must put aside our party affiliations, pre-suppositions and needless vitriol on behalf of the public good. A more civil discourse — one that balances the benefits of private capital diversification with a reform agenda that celebrates the primacy of client interests — is sorely needed.
John Bowman is senior managing director of the Chartered Alternative Investment Analyst Association (CAIA).