Wealth Matters
The Allure, and Burden, of Private Equity
By Paul Sullivan
Private equity offers the promise of exclusive deals, outsize returns and enviable cocktail parties.
But as seductive as these investments are, they can trap investors with onerous restrictions like high capital requirements and longtime commitments.
Simply put, private equity is an investment in an asset that is not traded on a public stock market. It’s a catchall term that also includes debt, real estate and various esoteric forms of financing — all of which have different expectations and risks.
The high returns offered by these private equity funds, and the minimal regulatory oversight, draw investors with deep pockets, like pension funds and wealthy individuals, who can meet the minimum investment requirement. The downsides are that the fees are high and the money is typically locked in for at least four to seven years.
That has not stopped the industry from growing. Private market fund-raising rose nearly 4 percent globally in 2017 to $748 billion, according to a review by McKinsey & Company. That year, the private equity firm Apollo Global Management raised a record $24.6 billion for its ninth fund.
But investors must understand the risks. Private equity investments are less liquid than public market securities, for starters, which makes them harder to cash out in a market downturn. And investors may be required to put in money later, an agreement known as a capital call.
“You always have to think about the margin for safety,” regardless of the type of investment, said Tony Roth, chief investment officer at Wilmington Trust. “What happens if it doesn’t turn out the way you’re thinking?”
This is the fourth in a five-part series looking at highly desirable assets that can deliver great returns but can also become burdens when owners need to offload them quickly. Previous columns have looked at art, cars and collectibles.
Private equity is different from the other types in this series because it is a financial investment, not a tangible asset. You can’t hang it on your wall, park it in your garage or serve it with dinner. But it has a cachet from the past successes of other investors, and the high barrier to entry creates an air of intrigue.
The first step to making a private investment is understanding the pitch. After all, there are some 7,000 private investment managers across the globe.
Determining the skill of the manager is important, so do your homework. Andrea Auerbach, global head of private investments at Cambridge Associates, a consultant and an adviser, said picking an average manager could affect your bottom line.
The difference in returns between public equity managers who are in the middle of the pack and top performers was less than three percentage points, she said. But when it came to private equity, the difference in returns between mediocre and top managers was 21 points.
A second step is spreading money across funds raised in different years, not just with different strategies. For instance, funds raised in the years before the recession made most of their investments when the market was at a peak, so they consequently performed worse than those that raised money in the years right after the downturn, when asset values were lower.
A bigger problem for investors in 2008, though, was that private equity firms demanded money from investors in a capital call. The timing was bad because some investors had put their money in the stock market and had to sell their shares at steep discounts to avoid defaulting.
“Most investors oversimplified it, which increased their risk,” said Adam I. Taback, deputy chief investment officer for Wells Fargo Private Bank. “You have to figure in the growth of every other asset. What’s happened to the other 90 percent of your portfolio while you’re doing all this private equity planning?”
Patience is a necessity in private investments.
The marketing material for these funds suggest the investment will last about seven years, but in reality, with clauses in the documents about mandatory extensions, some of these funds can drag on for twice as long.
“Let’s say you make a commitment to a manager and they turn out to be not who you think they are,” Ms. Auerbach said. “You can try to sell your slightly used private equity stake on the secondary market, or you can do your homework and make sure you can stay with the manager for 12 to 15 years.”
“Everything,” she added, “takes longer than people think.”
In the current economic cycle, advisers are urging their clients to do more due diligence and be cautious. “With at least a five- to seven-year outlook, it’s almost certain there is going to be a recession during that time frame,” Mr. Roth said.
Investors should factor in periods of volatility. “When you know you’re going to have a recession, you need a much larger margin of safety than earlier in the cycle,” he said.
To this end, Mr. Roth said, Wilmington Trust has formed partnerships with various private equity firms on behalf of its clients to make niche investments. One involved investing in distressed loans in Europe.
In another recent deal, Wilmington Trust joined forces with a private equity firm that invested only in digital and personal security companies. Its $700 million fund, entering its second year, has already returned capital from successful deals.
Uneven allocation can be a problem. As a private investment matures, managers are both asking for capital and returning money from earlier investments.
“If you have $10 and want to go into small-cap equity, you write your check and you have your $10 of exposure,” said Katherine Rosa, global head of alternative investments at J. P. Morgan Private Bank. “With private equity, you commit capital and that’s drawn down over three-, four-, five-year periods and the distributions come back to you when the manager decides to sell that position.
“So at any time,” she added, “the most you’ll be out of pocket is between $6.50 and $7.50 out of that $10.”
That dynamic has tripped up some investors who pledged money to private equity funds that was allocated to another investment, hoping their returns would cover the call for more capital.
For investors new to private equity, buying a stakes on the secondary market may be a good entry point, Ms. Auerbach said, because the buyer will have a sense of the fund’s performance and get returns more quickly.
But the question remains: How much do you put into private equity to reap the benefits but avoid the downside? Unfortunately, there is no hard rule like the 60/40 split between stocks and bonds that serves as a baseline for investing in the public markets.
Ms. Auerbach wrote a paper analyzing the private investment strategies of top-performing institutional investors and what individuals could learn from them. She found that most big institutions had at least 15 percent of their portfolio in private investments, with some going more than 40 percent.
She said large, multigenerational families might be able to do the same, given their wealth and ability to remain comfortable with the illiquidity.
Of course, that percentage depends not just on the asset base but also on a family’s spending. Ms. Rosa said clients needed to think about whether they could get returns on their other investments that were high enough to cover their lifestyle while they waited for their private equity investments to mature.
That makes sense, but all those numbers need to be forecast out years, and by that time, the economy may have stalled.
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