On occasion, we are asked to review a variety of investments that fall under the category of private equity (PE). This could be through a new opportunity or a holding in a new client’s existing portfolio. While the PE universe has grown substantially over the last 20+ years, it’s worth examining when and if the potential gains of investing in the asset class are worth the substantial risks.
As defined by Investopedia, private equity is “an alternative investment class consisting of capital that is not listed on a public exchange. Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.”
The Journal of Alternative Invesments’ Winter 2020 issue featured a study conducted by Antti Ilmanen, Swati Chandra and Nicholas McQuinn of AQR, a global investment management firm, attempting to “demystify” some of the risks in PE investing, particularly around their illiquid nature, and arrive at some estimation as to future expected returns. While not exactly light reading, I’ll attempt to provide a high-level overview of the pros and cons below as we attempt to assess its place in a portfolio.
We’ll start with some of the reasons why we’ve seen such an increase in PE investing.
Increased Accessibility & Allure
The popularity of private equity investing has certainly grown over the last few decades. According to Institutional Investor, “the private equity industry has surged from roughly $1 trillion in assets in 2004 to nearly $4.5 trillion at the end of last year (2019), a compound annual growth rate of 10.8 percent.”
As opportunities to invest in the space have grown, it has shifted from being the market of an elite few to the stuff of business news headlines and golf course or cocktail party banter.
Beyond the natural appeal of investing in something touted as “private” and not available to all investors, there’s also a belief that private companies increasingly delay entering the public market due to the cost and tedious nature of keeping up with regulatory compliance and shareholder demands. By the time some of these companies finally do go public, the thought is that much of the growth opportunity has passed investors by.
Some argue that investing in private equity inherently increases diversification in a portfolio. The argument being that private firms are not correlated to certain forces in the public market and, as such, allow it to behave differently enough from public markets to add value to a well-diversified portfolio.
Some are drawn to the private equity space by what appear to be smoother, less volatile returns. This makes some intuitive sense as there are fewer players in the market compared to public markets where hundreds of millions of investors trade billions of shares on a daily basis.
While an admittedly brief and overly simplified list of potential advantages to PE investing, it provides a small window into why the asset class attracts the interest that it does. But after considering these advantages, it is important to also consider some of the potential pitfalls as well.
When making a PE investment, an investor is generally committing to tying up their capital for anywhere from 5-10 years depending on the specific offering. This means that an investor either cannot liquidate their funds when they want or could face potentially high losses if they do.
Some argue that this lack of ability to get to your money is countered by something known as an illiquidity premium, meaning investors should be rewarded with higher returns for tying up their money for longer than the public markets which can be liquidated at any time. AQR’s study was inconclusive at best as to whether this premium actually exists meaning investors may not be sufficiently rewarded for the risk they are taking with these types of investments.
Illusion of Stability
According to the AQR study, investors are willing to exchange some of that illiquidity premium for the perceived stability or smoother returns in the private markets. AQR’s study counters that this is an illusion, largely explained by how and when their valuations are reported. Commonly, private equity values are based on appraisals or self-reporting, which done infrequently, makes it appear as though these companies are not fluctuating in value. Conversely, publicly held companies fluctuate in value on any day the stock market is open for business.
In other words, you may receive a statement from a private equity investment showing little to no change in value over the prior period simply because there has been no formal revaluation of the company’s health during that time.
While most people who invest in private markets understand this risk intuitively, the lack of seeing adjustments in value on a regular basis can create a cognitive bias that causes investors to underestimate the amount of risk being taken.
Going back to Investopedia’s explanation, a “private equity fund has Limited Partners (LP), who own 99 percent of shares in a fund and have limited liability, and General Partners, who own 1 percent of shares and have full liability. The latter also have responsibility for executing and operating the investment.” This shouldering of responsibility comes at a cost, often 2% in the form of a management fee and an additional performance fee of around 20% for any profits from the investments.
Even when you assume that some ill-performing funds are not subject to that 20% fee or that different fee structures have been introduced in some firms, using the 2017 McKinsey CEM Benchmarking survey average of 5.7%, it’s easy to see how high a hurdle private equity investments have in needing to substantially outperform public markets to cover their expenses.
While TAAG does not utilize private equity in our models, it’s not to say that the asset class doesn’t have a place in certain investor portfolios. It’s just vitally important that investors understand what that place might be, the risks involved and verify that the perceived benefit they’re getting for such an investment actually exists.
As demand will likely continue to increase even in spite of relatively poor performance, the hope is that access to diversified pools of private equity investments at increasingly lower costs will present themselves. Vanguard’s somewhat controversial announcement earlier in the year that it will begin offering such a fund, albeit just for institutions for now, might be the beginning of such a shift. But the counter argument is that for that to occur, transparency and oversight must increase which, in the end, will make the private markets looks increasingly like the public ones.