Private equity funds have grown hugely in popularity in recent years, as investors reach for extra yield. Traditionally aimed at institutional investors, they're increasingly being targeted at wealthy individuals. But, as I explain in my latest piece for the Financial Suitability Forum, advisers should think very carefully before they recommend them.
One of the more surprising stories in the asset management world in recent weeks has been the announcement that Vanguard is entering the private equity space.
PE is, after all, a “hot” sector, and Vanguard has historically shied away from fashionable investment trends. It’s also an asset class that, until now, has only really appealed to institutional investors; Vanguard, of course, is known as a champion of ordinary investors.
As a huge fan of Vanguard myself, I must say I’m puzzled and concerned by this latest departure. Why? Because, because private equity funds raise a number of suitability concerns. Here are five reasons why advisers should think very carefully before recommending them.
1. Fears are growing of a PE bubble
Private equity is growing at a remarkable pace. According to a study by State Street in October 2019, the public equity market has doubled in size since 2000, but private equity has expanded sixfold over the same period, to around $2.5 trillion.
In his latest annual letter, Seth Klarman from the hedge fund Baupost warned that the “unprecedented” amount of money pouring into the sector had produced “bubble or near-bubble conditions”.
Patrick Jenkins, the deputy editor of the Financial Times, shares his concerns. He claims that demand from institutional investors means that “private equity firms now have far more money than they know what to do with” and that average leverage multiples (the amount of debt relative to profits) have risen sharply. It’s only a matter of time, says Jenkins, before the bubble bursts.
2. Returns have lagged public stock markets
Of course, the reason investors are looking to private equity is that they want to achieve higher returns than they would in public equity. It’s true that, in the past, PE has outperformed global stock markets.
But a new report by the Harvard economist Josh Lerner and the consultancy firms Bain and Company shows that, in the ten-year period to the end of June 2019, private equity funds underperformed public equities. Investors in PE funds received an average annual return of 15.3% compared to the 15.5% than they would have made by investing in the S&P 500.
“There’s been a huge influx of money into private equity, said Professor Lerner. “But when you look at the returns numbers for the last decade… it’s hard to feel that there’s really been much alpha at all.”
3. There may not be an illiquidity premium
Another reason why investors have opted for private equity is that it’s generally assumed to offer an illiquidity premium. In other words, investors should receive a higher return as compensation for not having instant access to their assets. But the very existence of an illiquidity premium is open to question.
In a 2017 study, Erik Stafford from Harvard Business School showed that the premium is actually “zero or even negative”, and that an investors can achieve similar, and perhaps slightly better results, with a portfolio of publicly traded small-cap value stocks.
In a blog post published in December 2019, Cliff Asness from AQR Capital Management suggested that it’s more appropriate to refer to an illiquidity discount. Yes, returns appear to be smoother than for public stocks, because investors aren’t confronted with rising and falling prices every day. But the volatility is actually comparable.
4. PE provides very limited diversification
Another argument that is often made to justify private equity exposure is that it provides diversification. But how valuable is that diversification in reality?
Proponents of PE often suggest that there’s a low correlation between private equity returns and stock market returns. But recent research suggests that the actual correlation is rather higher.
Nicolas Rabener from Factor Research, for example, says the perception that private equity is less volatile than public equity is purely down to the smoothing of returns. His research shows how the correlation is in fact a positive one, and that PE is just as volatile, if not more so. In comparison, bonds were negatively correlated to equities from 1994 to 2019 and so offered much better diversification.
5. Funds often lack transparency
Advisers are increasingly aware of the many ways in which managers of public equity funds can make their performance look better than it really is. But it’s even easier for a private equity fund to dress up its figures.
In his book Private Equity Laid Bare, Professor Ludovic Phalippou from the University of Oxford showed how the widespread use of the IRR, or internal rate of return, as a measure of performance is open to abuse. Because fund managers control the timing of cash flows, he argued, they are able to cite an IRR that has little connection with investors’ experience.
Professor Phalippou is also concerned about a lack of transparency around fees and charges. The headline charge, he says, is “meaningless”, and transaction costs are frequently overlooked. The total amount that investors pay is often far higher than they realise.
With all these downsides, you may be wondering why private equity investing continues to reap record sales. According to a recent report, PE funds attracted $301 billion in new assets last year in the US alone.
The reason may be largely behavioural. Professor Meir Statman from Santa Clara University explained in an interview with the American Association of Individual Investors, that “investments are like jobs”, that “their benefits extend beyond money” and that “they express parts of our identity”.
He said people some people invest in hedge funds for the same reason they buy a Rolex watch or carry a Gucci bag — they are expressions of status, available only to the wealthy. The same thing often applies to private equity investments.
Yes, PE funds may be all the rage. But it’s very hard for a fiduciary adviser to make a coherent case for recommending them.