Jul 2017 by Caroline Rasmussen
According to Private Equity International, US individuals increased their exposure to private equity by 20% between Q3 2015 and Q3 2016 - the biggest year-on-year growth among the largest categories of investors in the asset class.
According to Private Equity International, US individuals increased their exposure to private equity by 20% between Q3 2015 and Q3 2016 - the biggest year-on-year growth among the largest categories of investors in the asset class. Clearly, private equity’s value proposition is increasingly being recognized by this segment of the market, but it’s important for individual investors to take a close look at their investment priorities and educate themselves on the asset class before jumping in. This includes asking the following five key questions:
1. What is my investment timeline and tolerance for illiquidity?
2. Am I comfortable with the fees?
3. How do I research and evaluate private equity opportunities, and can I get access to top quartile managers?
4. What types of strategies and allocations make sense based on my existing portfolio holdings and risk tolerance?
5. Once I’m invested, how does reporting work?
True private equity is the ultimate in active management. Skilled private equity managers effectively anticipate industry trends, identify companies with opportunities for growth, and implement value creation strategies such as reducing operating expenses, optimizing asset utilization, or making accretive add-on acquisitions, to generate superior returns over time. However, sourcing the right deals, executing operational improvements, and successfully exiting investments requires time. Capital lockups are by definition required to produce the illiquidity premium private equity is known for.
Family offices and endowments have allocated aggressively to private equity for many years. According to Cerulli, family office allocations to PE average around 26%, while the average endowment allocation is about 12% (although leading endowments such as Yale seek to allocate as much as 50% of their portfolios to illiquid assets).1 However, these investors have indefinite investment horizons and thus a high tolerance for illiquidity. It is worth noting that "private equity" can encompass a wide range of strategies within an illiquid structure, including buyouts, venture capital, private credit, real estate, and infrastructure. While buyout funds typically have 10-year terms in order to enable managers to effectively create value, credit oriented strategies can have shorter terms of three to five years (and often offer a current income component that helps mitigate their illiquidity).
Particularly for longer lived PE strategies, assets earmarked for retirement as well as those intended for intergenerational wealth creation can be a good fit to fund allocations. However, it’s critical to ensure a thorough understanding of private equity’s "drawdown" structure when thinking about how much illiquidity you can afford. Investors in a private equity fund agree to invest a set amount of money, referred to as making a capital commitment. However, unlike in public market investing, the capital is not invested right away - as the fund manager finds companies in which it seeks a stake, it collects a portion of the commitment via a capital "call". While investors do not need to fully fund their commitment upfront, defaulting on capital calls can carry serious penalties, including forfeiture of any dollars funded to date, so investors must be able to manage their cash to meet calls when they come due. Investors receive distributions later in the fund’s life, when investments are recapitalized or sold.
Private equity funds typically charge annual management fees of 1.5 – 2% of committed capital. While higher than the fees associated with many passive public funds, good PE managers take a very active role in the management of their portfolio companies, unlike what is possible in a public market context.
A key difference then between traditional public funds and private equity is PE’s inclusion of carried interest, generally 20% of a fund’s profits. Carried interest is a performance or incentive fee paid to the manager. Because it represents the lion’s share of the manager’s compensation in connection with a given fund and is only paid if the fund achieves a certain threshold or “preferred” return (typically 8%), it aligns the interests of the manager with those of investors.
While traditional public investments are largely beta-driven with low dispersion across managers, private equity returns are driven by manager skill, and there is significant dispersion between individual fund returns. According to a recent KKR report, the spread between top and bottom quartile managers in buyout and venture capital is about 10%, compared to just 2% for US fixed income and public equity managers, making informed manager selection critical.2
Comparing the fund returns of a given manager with those of funds of comparable size and strategy in the same vintage year (the year a fund makes its first investment) is the first step in a manager evaluation process. Once benchmarking has shown a manager to be consistently top quartile, investors must proceed to determine the key factors that drove prior success and whether those factors are still present and relevant going forward. This includes evaluating how a manager has created value; adjusting a company’s capital structure via financial engineering and selling a company at a higher multiple than that for which it was acquired tend to be market-related factors that can expose undisciplined managers when conditions deteriorate. On the other hand, increased revenue and EBITDA across the portfolio is strong evidence that a manager can deliver private equity alpha.
In addition to understanding how value was created within individual portfolio companies, institutional diligence necessitates disaggregating a fund’s overall cashflows to analyze performance by attributes such as sector, equity check size, source of investment, geography, and lead investment professional. These analyses reveal qualitative insights such as whether a manager’s overall returns were driven by a particular industry or secular trend (which may no longer be attractive), and enable investors to ask the right questions, such as whether a particular sector will be more or less of a focus in the next fund.
Because of the wide return dispersion in private equity, investors considering the asset class need to ensure that they have access to high quality, top quartile managers. In a stark illustration of the importance of manager selection and access, CalPERS’ Head of Research recently disclosed that the pension’s top 40 managers, out of a stable of 350, produce about 90% percent of the PE portfolio’s total gains.3 Historically, getting in to top quartile funds has been difficult for individual investors given short fundraising timeframes, high minimums, and a willing roster of institutional investors willing to meet these requirements based on historical performance. However, this is beginning to change as the industry recognizes the importance of the individual HNW investor market, and new platforms are emerging to facilitate HNW investment into private equity.
Traditionally, investors have thought about allocations by asset class: public equity vs private equity, public debt vs private debt, and so on. An alternative approach is thinking about private drawdown strategies within the context of equity vs credit vs real asset exposure. In other words, first consider how much of your total portfolio can be locked up for longer terms, and then allocate that illiquid bucket across strategies according to your goals and risk tolerance.
For example, investors looking to achieve higher returns from their equity exposure might consider adding a growth equity fund (or a top tier venture capital fund, if they can tolerate higher risk). Another common goal today is enhancing the anemic yields offered over recent years by traditional fixed income. Strategies such as private direct lending and structured credit can be accretive in this regard, something UHNW investors have acted upon in allotting almost half of their overall fixed income allocations to private credit, according to a recent survey.4 Direct lending itself offers a variety of risk/return profiles, with some firms focusing on senior secured loans and others making riskier, but higher coupon, subordinated loans. To provide another example, many individual investors have REIT exposure within their real asset allocation, even though REITs historically have performed more like stocks than real estate. Investors seeking a true inflation hedge with low volatility might consider private real estate funds, which again, offer a range of risk/return profiles from core-plus to greenfield development.
While PE managers report returns and significant portfolio developments to their investors on a quarterly basis, illiquid holdings are inherently difficult to value and it can be hard to quantify the impact a manager has had on underlying investments until those investments are sold. This is why thorough due diligence is key prior to investing. Investors who seek consistent reassurance on performance via daily price quotes or frequent reporting should generally look elsewhere.
Quarterly reports generally disclose four fund metrics: IRR (Internal Rate of Return), Total Value to Paid In Capital (TVPI), Distributed to Paid In Capital (DPI), and Residual Value to Paid In Capital (RVPI). The IRR, which should always be assessed net of fees, is a time-weighted return that takes not just the amount but also the timing of fund cash flows into account. Because IRR can be dramatically impacted by the timing of inflows and outflows, TVPI, which simply divides the total realized and unrealized value of the portfolio by the amount of capital invested, is a useful complement. TVPI, effectively the fund’s investment multiple, can be arrived at by adding DPI and RVPI. DPI is calculated by dividing cumulative distributions by paid in capital. This ratio grows over time and becomes more relevant as a fund matures. RVPI is calculated by dividing the fair market value of a fund’s unrealized, or "residual", investments by paid in capital. RVPI shrinks over time, as the fund sells investments. The higher the RVPI, the greater the potential to realize additional gains over time.
Individual investors must take many things into account when incorporating private equity into their portfolios, including their return objectives and other goals, risk appetite, investment horizon, and the size of their assets. Given the wide dispersion of private equity returns and the fact that investors’ funds are locked up for 10 to 12 years, rigorous due diligence is also essential. For those investors with the requisite assets, time horizon, risk tolerance and access, private equity can add meaningful diversification and return enhancement potential to a traditional portfolio.
This article originally appeared in Financial Poise.
(1) Cerulli data as of March 31, 2015; Yale endowment 2016 annual report.
(2) May 2017 KKR family office survey
(3) Private Equity International, Desrochers on CalPERS 2.0, April 6, 2017.
(4) May 2017 KKR family office survey
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