De-Mystifying the Private Equity Sector
A recent dip in interest rates and highly valuated US stocks have investors looking further into alternative investment options, including private equity. But economic conditions aren’t the only reason PE has grown in popularity. As Larry Swedroe of Buckingham Strategic Wealth points out, “PE excites many investors, offering the opportunity for spectacular returns (although, as with most investments, we generally hear only the stories with happy endings). Even the term conveys an exclusive nature, especially for investors who yearn to be ‘players.’”
As of this year, the leader in low-cost index funds, Vanguard Group, has even announced their entry into Private Equity. Chief Executive, Tim Buckley, explained the company will first offer their private-equity fund to endowments, foundations, and institutions and then on to wealthy individuals who use its financial-advisory services. [i]
Are PE investments really all they are cracked up to be? Do they offer the spectacular returns they tout or is it all hype? Is this trend into PE worth following?
What is a Private Equity Investment?
On the most basic level, private equity is owning a portion of a company that is not publicly owned. The investor contributes funds that will generate growth, finance an acquisition, or allow the company to restructure and sell for profit.[ii]
The process includes:
- Making a Capital Commitment: The investor legally agrees to pay a certain amount of money to a fund over time, anywhere from 2-5 years.
- Your Capital is Invested through Drawdown: The fund manager uses the investor’s committed capital to purchase attractive investments.
- You Receive Distributions: As the fund manager sells investments or takes the company through an initial public offering, distributions are paid to the investors as cash (or possibly to offset future drawdowns, in some situations).
Overall, the process could take a decade before investors see returns. First and foremost, most individuals don’t have millions in discretionary capital to invest directly in the PE sphere, and even if they do, they may not want to make the time commitment required of their funds.
How to Invest in PE
There are alternative options to providing millions in capital to fund a private equity event. As an individual investor looking to enter the PE sector with less capital and fewer risks, there are a number of ways to invest. The most common ways are by investing in PE exchange-traded funds (ETFs) or buying public shares of companies that manage the funds, such as Blackstone Group (BX) or KKR.
PE exchange-traded funds (ETFs) track an index of publicly traded companies that invest in private equities. There is no minimum investment requirement, but they do come with management fees and brokerage fees that can significantly reduce your return.
Buying public shares of private equity management companies is a way to gain access to the PE sphere and theoretically add diversification to your portfolio, since fund managers are supposed to invest in a range of funds which would spread out overall risk.
Are PE Investments a Good Choice for Me?
As an investor, it’s hard to ignore the headlines when there seems to be a good opportunity on the horizon. But like with any investment choice, you must put your emotional impulses to the side and look at the picture logically. You must weigh the perceived risks with the potential reward to determine if PE investments are a smart choice or just a popular one.
The question then becomes whether PE funds have historically outperformed publicly traded mutual funds and securities, and if they have, is it enough to counterbalance the fees assessed?
The Myths Favoring PEs
#1: PE options have generated copious wealth for general fund partners.
Reality: This is true, but when it comes to PE investing, there are two types of investors that stand to benefit: the general partners of the fund and the limited partners, the investors themselves. But, these fund managers (a) have more invested, and thus more to gain and (b) aren’t being hit with the same management and brokerage fees as the individual investors. So, not only is an investor receiving a significantly smaller return, that return is also being reduced by fee payments.
#2: PE indexes are less risky.
Reality: PEs create the illusion of less risk because of a lack of market-to-market accounting, evaluating performance over longer holding periods, and laissez-faire valuation procedures.
#3: PEs outperform the public indexes.
Reality: There are cases in the past when PE indexes produced a higher percentage rate return, but (1) these publicized returns were not adjusted for risk, (2) often did not deliver post-fee alpha, and (3) were not consistently outperforming over a given period. And much like timing the market, or trying to determine when one stock will skyrocket and another will plummet, there is no predictable, educated way to foresee which PE funds will be the ones to outperform. Doing so is taking a shot in the dark with your money. [iii]
For investment firms, PE offers an opportunity to tie up large sums of money and capture fees on transactions for longer than stock and bond strategies. But is it worth it for the investor?
In his recent article, “How Private Equity Destroys Investors' Wealth,” Larry Swedroe compiles decades of quantitative research that all point to the following conclusion: “When properly adjusted for risks, PE returns lag those of the less risky public markets. Moreover, there is little evidence that investors can identify, in advance, the very few PE funds that will outperform.”
So, despite the romanticism and media hype, these investments are accompanied by much higher risk and seldom offer greater reward.
Interested in learning more about the future of PE? Feel free to reach out. We are always available to discuss your investment choices.