How To Determine if Private Equity Makes Sense for Retail

Are you currently considering adding private equity to your investment portfolio?  Private equity has recently become the most popular alternative asset class for wealthy investors given its ability to provide higher returns, lower volatility, and diversification away from public markets.  Bain recently reported that retail investors represent ~50% of global assets under management, but only ~16% of alternative investments. This disparity in opportunity has led brokerage firms to develop private equity offerings targeting retail investors. In this blog post, we discuss private equity’s business model and key considerations for average investors to evaluate before investing their capital. Don’t get into it just because Kim Kardashian has her own private equity company.

Industry Overview

Private equity firms invest capital directly into private companies that are not publicly traded on the stock market. These firms raise capital from various sources, such as institutional investors, high-net-worth individuals, and pension funds. They acquire ownership stakes in private companies with the aim of generating significant returns on their investments.

Private equity firms typically follow a specific investment strategy. They acquire companies that they believe have the potential for growth and increased profitability. This may involve purchasing a controlling stake or a significant minority stake in the company. Once they have acquired the company, private equity firms work closely with its management team to implement operational and strategic changes that can enhance the company’s value. Examples of the top US private equity firms based on assets under management through Q1 2023 include the following:

Private equity firms typically hold their investments for a certain period, often between three to seven years, although it can vary. During this holding period, they actively work to improve the company’s performance and increase its value. They may introduce operational efficiencies, implement growth strategies, make strategic acquisitions or divestitures, and improve the company’s financial structure.

Private equity firms make money primarily through two main channels:

Capital Appreciation: The primary objective of private equity firms is to increase the value of the companies they invest in. They aim to improve operational efficiency, grow revenues, expand market share, and enhance profitability. By achieving these objectives, they aim to increase the value of the company over time. When they eventually exit their investment, either by selling the company or going public through an initial public offering (IPO), they seek to sell at a higher valuation than their initial investment, thereby generating capital appreciation.

Management Fees and Carry: Private equity firms charge management fees to cover their operational costs, including due diligence, deal sourcing, and ongoing portfolio management. These fees are typically a percentage of the committed capital or the total assets under management. Additionally, private equity firms also earn carried interest or “carry.” Carry refers to a share of the profits generated by the investment. It is usually calculated as a percentage of the investment gains or profits realized by the firm above a specified threshold. Carry is a way for private equity firms to align their interests with those of their investors and generate substantial income when investments are successful.

Below, we review the common advantages and disadvantages with private equity investments:

Advantages:

1. Opportunity for higher returns vs. public investments
2. Increased diversification vs. public investments
3. Less day-to-day volatility vs. public investments
4. Tax advantages such as deferring taxes until the investment is sold

Disadvantages:

1. Higher management & incentive fees (e.g., 2% management and 20% performance)
2. Limited transparency on performance and sector specialization required to research products
3. Unpredictable or infrequent income distributions
4. Restrictions around timing and liquidity

Investing Considerations

Private equity firms and other money managers love to highlight private equity’s returns, but average investors need to consider multiple factors before investing in these types of funds. Below, we summarize 5 considerations to inform whether private equity investments align with your investing objectives:

1. The average holding period for private equity is 5 to 7 years. 

Can a retail investor really tolerate this holding period and wait this long?  According to an analysis conducted by the New York Stock Exchange (NYSE), the average investor holds shares of a stock for only 5.5 months!  Back in the 1970s, the average holding period was 5 years!  Please see the declining trend in the average US equity holding periods below:

There are several reasons why the average holding period is much shorter today which include larger markets, more players and securities, algorithmic trading, lower trading costs and lower barriers to entry.  The recent rise of Robinhood, meme stocks, and day trading has only accelerated this trend.

Regardless, most investors may now lack the patience and no longer favor the “buy and hold” approach. Private equity investments may not be a good fit for investors that are impatient.

2. No income or unpredictable distributions during holding period. 

Most private equity funds do not pay a dividend or provide distributions. Any payouts during this holding period are entirely at their discretion.  For some investments, they may reward investors with a discretionary payout because there was a recapitalization or they liquidated some of their underlying assets.  However, this should not be the normal expectation. As an investor, can you tolerate not receiving any money during this 5-7 year holding period?  Long-term growth investors may not have this problem; however, income investors may struggle. Income investors expect to earn regular dividends as a way of “getting paid” to buy and hold the stock even if they are reinvesting it. 

However, if there is no income, does the incentive change your outlook and willingness to buy and hold?  

3. Private equity may perform similarly to the S&P 500 after fees and taxes. 

According to a recent presentation by Blackstone, the average PE return over the past two decades is ~12% while the S&P 500 yielded ~8%.  After fees and taxes, this incremental 4% return may yield similar returns.

Ludovic Phalippou from The University of Oxford conducted a recent returns analysis that compared private equity returns to the public equities market, by analyzing the net multiple of money. His results demonstrated that the average net multiple of money ranged between 1.55X to 1.63X, implying an annual return of ~11%. Private equity fees typically range between 2-3% of invested capital and carry, which represents 20-30% of fund profits in excess of a specified return hurdle of 6-8%. Additionally, if financial advisors introduce and place you into these private equity funds, they may charge a one-time placement fee of another 1-2%.

Your performance at the end of your holding period may be no better than the S&P 500.  Is it worth tying up your money with no liquidity during the holding period just to have similar returns as the S&P 500?  Shouldn’t investors be rewarded a premium for not having liquidity, PE firms playing an active role in creating organic/inorganic value for portfolio businesses and the opportunity costs for our money?

Of course, there are individual private equity funds that have significantly outperformed the S&P 500 index.  For example, if we examine CalPERS‘ private equity fund investments, there are individual funds that have returned anywhere from 2.9X to 4.2X of the invested capital, see below:

Note: We did not list all of CalPERS’ private equity program funds in the table below. We only listed the ones with the highest investment multiple for reference.

However, not everyone has access to investing in these individual private equity funds and historical results does not guarantee future performance, especially during a time when cost of debt is expensive!

4. Minimum investment amounts make opportunity costs high.

Most private equity investments will require a minimum investment amount and investors need to have accredited investor status. According to Morgan Stanley, many private equity funds will require a minimum investment of $10M or more if you choose to invest directly. However, through Morgan Stanley as well as other brokerage firms, regular investors may participate with a minimum investment of $250K.  We have listed the minimum investment amounts required by other brokerage firms below for private equity funds:

• Vanguard Harbourvest: $500K
• Charles Schwab Alternative Investment Platform: $100K
• Fidelity: $100K
• Morgan Stanley: $250K

While $250K is much lower than $10M, this initial investment is still extremely high and may prevent you from making investments in other areas (e.g., real estate, private credit, fine art, hedge funds).

How do you decide?  It’s unlikely that you can split this money across multiple asset classes given the high minimum requirement.  Therefore, investors have to choose.

5. Limited transparency makes picking private equity funds risky.

Since private equity funds invest in private companies, they are less transparent about the details of their underlying investments and are not obligated to disclose any details that are not aligned with their interests.  Furthermore, unlike public companies, private companies do not need to perform audited financials and thus, you are limited to the investment materials the PE firm provides.  As a result, it is much harder for the average investor to pick the RIGHT private equity funds vs. picking ETFs or stocks.  Less information and transparency makes it more difficult to make informed decisions.  Therefore, there is greater likelihood that you may end up with average returns.

Conclusion

While private equity investing may offer attractive returns, there are several other factors that may impact your decision to invest.  Liquidity, lack of income during long holding periods, returns expectations, fees and lack of transparency into underlying investments should also be part of your decision-making process.  Think carefully about how you allocate your money relative to illiquid alternative assets to make the best-informed decision based on your investing priorities and preferences.