Over the last decade, it’s become increasingly difficult to build a portfolio that can support a reasonable level of spending (3 percent to 5 percent per year) and still maintain its purchasing power over time. A 60/40 stock/bond portfolio over the last 10 years, for example, has delivered a total return of 50.1 percent (measured by 60 percent S&P 500 and 40 percent Barclays Aggregate Bond Index).1 When factoring in a conservative spending rate of 3 percent per year, the total return for the portfolio would have been 11 percent. That would have significantly underperformed inflation, roughly 27 percent for the same period, and would almost certainly have lost value in real terms.2
Investors who increased risk in their portfolios to compensate for lower real returns wouldn’t have achieved much better results. The problem is twofold: Public equity markets have been anemic for the last 10 years (Dec. 31, 2001 to Dec. 31, 2011; an average return of 2.9 percent per year over that period, compared to an average return of 12.9 percent per year for the prior 10 years3), but with markedly higher levels of volatility (20.5 percent over that period compared to the prior 10 years of 17.3 percent4). Therefore, during this period, an increased level of risk in the portfolio added a material level of volatility, but didn’t significantly increase returns. When considering spending from a portfolio, higher levels of volatility tend to be magnified and result in even lower average annual returns—exactly the opposite of the intended result. Only when a portfolio’s total return is more robust can one hope to increase risk and still support a reasonable spending level, while also preserving the purchasing power of the portfolio over time.
For these reasons, among others, many institutional investors significantly increased their exposure to private equity (at the expense of public equity positions) over the last 10 years. Private equity can represent as much as 30 percent or more of some institutional portfolios.5
The story of private equity as an asset class is rather compelling: Over the last 10 years, the median annual return of all private equity managers was 12 percent, compared to 2.9 percent for the S&P 500.6 Top quartile managers would have performed significantly better. Further, private equity managers generally delivered their returns with similar or lower volatility than public equity managers.
However, ultra-high-net-worth investors may have difficulty replicating this result. First, large institutional investors often have regular in-flows of funds (that is, large pensions and university endowments that regularly receive contributions and gifts), which provide natural liquidity for their spending. This makes a large allocation to private equity easier in the short run. Second, large institutional investors have professional staff (and consultants) who can identify private equity strategies and managers poised to perform well. These factors enable institutional investors to avoid investing in bottom quartile managers who (during the same 10-year period) could have been flat or even lost money. (See “Historic Diversion,” p. 53.)
So, should ultra-high-net-worth families invest in private equity? The short answer is “yes,” although it may not be appropriate for every investor. The harder questions to answer are: what’s the right level of private equity for a portfolio’s liquidity needs, and how should a trustee or family invest in private equity?
Reasons for Performance
To answer both questions, it’s important first to understand why private equity tends to perform the way it does.
• Value-added investing. Public equity managers generally seek to own non-controlling pieces of public companies that they believe will either grow naturally or are underpriced and will appreciate once the market perceives their value. In contrast, private equity managers typically specialize in running businesses. They take a controlling interest in a business that’s either challenged or has untapped opportunities and provide strategic guidance to those companies on growing their business and applying best practices to improve product management, market positioning and financial performance.7
• Patient, disciplined capital. Public investors, even those with long-term views on a company, will typically experience turnover of 50 percent or more in a portfolio. Private equity managers, in contrast, are investors for multi-year durations, seeking out undervalued assets and maximizing their long-term potential.8
• Superior information. Unlike public equity, private equity investments are typically driven by unique access to industry and company information, access to management teams and competitive information that help facilitate control and, hopefully, investment returns.9
• Alignment of interests. An investor in a private equity fund is aligned with the private equity manager in a way that’s unusual to find with public equity managers. Typically, the private equity manager makes a significant personal commitment to the investment fund and doesn’t share in the upside of the investment until it exceeds a preferred return to investors.10
How it Works
It’s important to understand how private equity investments work. This can help a trustee or family in making asset allocation decisions.
An investor in private equity typically makes a commitment of capital to the investment and receives in exchange a limited partnership (LP) interest in the fund(s). A small portion of that commitment might be paid upfront. Over the first one to four years of the investment, the private equity manager will call additional capital from investors to make specific portfolio investments, usually up to about 75 percent of the commitment. This is commonly followed by a period of three to four years, during which the manager neither calls additional capital nor distributes returns to the investor. Finally, in years seven to 10, an investor may begin seeing returns on his investment, initially net of the final 25 percent of capital calls.
There’s generally no liquid market for LP interests (as the name “private” equity implies). While secondary markets have grown over the years, secondary buyers often command a significant discount to the carried value of the LP interest. Moreover, most private equity funds require the consent of the general partner (the fund manager) to sell the LP interest.
Given these conditions, private equity is much less liquid than traditional investments:
• The investment will require sufficient liquidity to satisfy the capital calls.
• The investment can be held for as long as seven years or more without seeing any distributions.
• The challenges of selling private equity make accessing
liquidity difficult in a number of ways: Lenders often don’t lend against private equity interests, a general partner might not allow the trustee or family to sell its interest in a fund and selling could result in a significant loss.
A trustee or family will want to limit its exposure to private equity to avoid such conditions as insufficient liquidity for spending needs or, worse, having to
liquidate part of their portfolio at an inopportune moment. The question then becomes, what’s an appropriate allocation to private equity, taking into account liquidity needs, while also recognizing the potentially greater risk-adjusted returns of such an investment?
One way to tackle the allocation question is to treat private equity as a less liquid component of an overall equity allocation. If a family or trustee would otherwise allocate 60 percent of the portfolio to equities, it might be reasonable to carve out 10 percent of that allocation for private equity (that is, 6 percent to 9 percent of the total portfolio). A 6 percent allocation to private equity would, most likely, not compromise a trustee’s or family’s ability to meet liquidity needs. Moreover, a trustee or family could, possibly, borrow against the public equity positions, if their liquidity needs were substantial.
Another way to address the allocation question is to treat private equity as a part of a less liquid “satellite” portfolio. A trustee or family could decide that 85 percent to 90 percent of its portfolio should be fully liquid and, therefore, invested in traditional asset classes. That would leave 10 percent to 15 percent to be invested in less liquid investments, such as real estate and private equity. Depending on the overall investment objectives, private equity might comprise 60 percent of the satellite portfolio (that is, 60 percent of the 10 percent to 15 percent, or 6 percent to 7 percent total allocation).
However, the decision to allocate 6 percent of a portfolio to private equity isn’t the same as saying the trustee or family should make a 6 percent commitment to private equity funds. This is due to the nature of how the capital is called. Capital calls in the first four years often won’t exceed 75 percent of the total commitment, and in later years capital is returned (either in the form of self-funding the last 25 percent of commitments or outright distribution). Therefore, a private equity investor should consider committing an amount larger than the intended allocation. For example, if a trustee or family determines it wants 6 percent allocated to private equity (or $6 million of a $100 million portfolio), it may be necessary to make private equity commitments of
$8 million. If the trustee or family commits just $6 million, their private equity investments may, ultimately, average only $4.5 million at any given time.
In any case, the trustee or family member should be sure to set aside the full amount of the capital commitment in cash to fund future capital calls. It would be unwise to make the commitment and later have to liquidate more investments (or borrow) to fund capital calls.
Size of Portfolio
No discussion of private equity is complete without considering the size of the trust’s or family’s portfolio. Private equity is an investment suitable for sophisticated investors only. By rule, an individual must have at least $5 million of investible net worth (excluding homes and other illiquid assets), and trusts must have $25 million of investible net worth. This factor immediately eliminates a large number of individuals and trusts from the scope of private equity.11
So, what are the challenges faced by trusts and families investing in private equity?
Like most other asset classes, diversification is an important aspect of private equity investing. Investors should select manager strategies likely to perform well over a 5-to-10 year period, not just by the asset class without consideration of the specifics of the investment. There are capable private equity fund-of-funds and capable private equity firms that offer many products and strategies. However, private equity funds are seldom top performers across all of their product offerings. Few trustees or families will have the expertise or resources to evaluate managers on these factors or to be able to identify the best in each strategy.
Though diversification is essential, with minimum investment sizes often in excess of $500,000 per manager, it will be very difficult for a trustee or family (even with professional help) to build a customized private equity portfolio with less than $100 million. A convenient solution for investors who can’t commit funds on such a scale is to invest in a fund-of-funds or through feeder vehicles. However, it must be acknowledged that funds-of-funds, typically, are characterized by additional layers of fees, less transparency and slower reporting.
While private equity generally outperforms public equity markets over time, the scale of outperformance is tied very directly to certain “vintages,” or years, in which investors made commitments to a fund. Some of the top performing vintages are correlated to periods of economic crisis and volatility. For example, managers taking advantage of conditions arising out of the 1987 stock market crash, the 2001 bursting of the dot-com bubble or the 2008 financial crisis were able to deliver exceptional returns.12 Part of the reason for such performance is that most private equity managers are willing to deploy capital when other traditional sources of capital aren’t readily available. This affords a private equity manager the opportunity to be selective about sectors, regions and companies and to make investments at attractive valuations with meaningful downside protection.
While private equity investors in early 2000 vintages might have experienced good but not compelling returns, there’s much to suggest that the current global economic environment is an opportune time to consider private equity.
Complex Asset Class
Like public equity, private equity is an asset class that should be part of a well-balanced portfolio. Given the illiquidity of private equity investments, trustees and families need to carefully consider whether a private equity allocation makes sense for their specific needs. The vehicles available for making private equity investments are somewhat limited, potentially making the choice to invest in the asset class challenging for some trusts or families. It’s a complex asset class best suited for sophisticated, patient investors, thus making it inappropriate for many trusts’ and families’ specific circumstances. Further, the opaque nature of the industry makes it difficult to identify opportunities without the help of sophisticated financial advisors.
Conversely, given the current financial environment—a prolonged period of challenging performance in public equities; harrowing global macro and political news that raises questions about the performance of the public equity markets in the next 10 years; and the understandable strain on trusts and families to support spending needs, while preserving the purchase power of a portfolio—a prudent trustee and family advisor should consider whether private equity has a place in the portfolio.
1. Bloomberg and FactSet. Illustrative portfolio total return represents a weighted average of each indices’ respective total return for the 10-year period
ending Dec. 31, 2011. S&P 500 total return assumes all dividends are reinvested. Barclays U.S. Aggregate total return assumes all coupons are reinvested.
2. FactSet. Represents total change in core consumer price index for 10-year period ending Dec. 31, 2011.
3. Bloomberg. Public equity market performance represented by performance of S&P 500. Assumes all dividends are reinvested. Period represents 10 years ending Dec. 31, 2011.
4. FactSet. Represents standard deviation of S&P 500 annual performance for the respective periods.
5. David Koh, “The Role of Private Equity in a Diversified Portfolio,” Deutsche Bank Private Markets Group.
6. Cambridge Associates LLC U.S. Private Equity Index and Selected Benchmark Statistics, Dec. 31, 2011.
7. Supra note 5.
11. Alternative investments (such as private equity) may feature highly illiquid securities that may be difficult to value. Such investments are speculative and involve a high degree of risk. Alternative investments are suitable only for “qualified purchasers,” as defined by the U.S. Investment Company Act of 1940, as amended and “accredited investors,” as defined by Regulation D of the 1933 Securities Act, as amended. An investment in private equity funds is speculative and involves significant risks including illiquidity, heightened potential for loss and lack of transparency. The environment for private equity investments is increasingly volatile and competitive, and an investor should only invest in private equity funds if the investor can withstand a total loss. In light of the fact that there are restrictions on withdrawals, transfers and redemptions, and private equity funds aren’t registered under the securities laws of any jurisdictions, an investment in private equity funds will be illiquid. Investors should be prepared to bear the financial risks of their investments for an indefinite period of time.
12. “Understanding private equity’s outperformance in difficult times.” Partners Group Research Flash, January 2012, Partners Group.
—This article is meant to serve as an overview and is provided for informational purposes only. It does not take into consideration the recipient’s specific circumstances and is not intended to be an offer or solicitation, or the basis for any contract to purchase or sell any security, or other instrument, or for Deutsche Bank to enter into or arrange any type of transaction as a consequence of any information contained herein.