For most private investors, the private equity market is not easy to break into. And for those who get in, there are many pitfalls, not least the high cost of most vehicles catering to smaller, private investors.
Private equity is a hot topic today because of its terrific performance over the last few years, the ever larger deals being pulled off and the creation of publicly-listed retail vehicles by big US brand names like KKR, Apollo, Blackstone, Carlyle, etc.
Why should (private) investors invest in private equity?
The best private equity managers deliver much better performance than public stock markets. The average private equity managers, however, do not. Private equity, on average, does not outperform public markets if measured over a sufficiently long period (20 years). Therefore it is important to invest in the best private equity managers. The difference between good and bad private equity managers is tremendous. The best can generate annual performances that are 15% - 20% better than the worst (measured as internal rate of return, or IRR), a much greater discrepancy than that found between managers of other asset classes.
Great difference between best & worst…
… of 1500 - 2000 basis points, larger than for any other asset class
Click on the image for an enlarged preview
Source: Venture Economics, all Private Equity funds cumulative pooled IRR performance since inception as of 30 September 2005
In other words, investing in private equity can be very compelling, but only if you have access to the world’s best managers.
Private investors in private equity are different
To begin, private investors are smaller than institutional investors and as such have less options at their disposal. However, private investors are not just smaller; we believe they are also different. We have listed below the main differences between private and institutional investors:
- Rational and emotional
- Often under-diversified
- Active interest (like a hobby)
- Long-term view, patient
- Seek personal contact
- Fast decisions
- Some deal-flow (mixed quality)
- Open to new approaches
- Smaller commitment size
- Administration not always optimal
- Disciplined (over-) diversification
- Passive interest
- Fast returns much appreciated
- Low maintenance
- Structured decision making
- Pure indirect investor
- Larger commitment size
There are different ways for private investors to take part in the private equity game. It must be kept in mind, however, that private equity remains private: by definition, these investments are not publicly traded on a securities exchange, and investors who do get in will have to stay with their investments for years before they can get their money back and cash in their profits. There are several solutions to make private equity investments tradable or liquid, and they are all expensive. Our view is that private equity is meant to be private and investors should keep it that way if they want to deal in this asset class. Any other solution tends to be a compromise and a costly one at that.
At Pictet, clients with less than CHF50 million in assets are typically not invested in private equity. This is not a hard and fast rule, but an investor should be able to live with the fact that he cannot touch his private equity investment for several years. If he cannot accept this, he or she should probably stay away from this asset class.
Smaller private investors may want look into the following options to invest in private equity.
Publicly-listed private equity vehicles
As mentioned above, this is not a preferred option and in fact virtually all the money invested in private equity today has stayed private. Publicly-listed vehicles are, and probably will remain, the exception, and account for only 1.3% of the total private equity raised in Europe in 2005 (source: EVCA/Thomson Financial/PricewaterhouseCoopers).
Nevertheless, there is a handful of publicly-listed vehicles, and in good times like today they tend to gain in popularity. There are two basic models:
- Single manager
Single manager listed vehicles
Groups like Permira, one of Europe’s largest and most successful buyout houses, can be bought through the publicly-listed company SVG Capital. It is an expensive way to gain access, but for small (private) investors it may be the only way. If the underlying private equity group is of good quality, this is not necessarily a bad idea (but watch the fees). The other interesting feature of such vehicles can be that it provides a mix of its most recent funds and earlier funds.
When times are good like today, many private equity groups try to get into the act of being listed. Recently KKR launched a US$5 billion listed vehicle. Other top names like Blackstone, Apollo, Carlyle, TPG have followed suit or are likely to do so soon, markets permitting. For private equity houses this steady source of capital is a Holy Grail. The traditional model is to return the money when investments are sold and re-start the cycle by raising another fund.
Single manager listed vehicles can be an interesting option if the manager is good. They do allow investors with a smaller ticket to enter the market, but the investor should do his homework on the underlying managers.
Multi-manager listed vehicles
This concept, in general, has not worked as well. Investors often do not value such vehicles at their complete (net asset) value and often end up with a share price well below the net asset value. The above-mentioned single manager funds also suffer from this effect, but to a lesser extent. When investing in a single manager vehicle, the investor at least knows what he is getting and can assess who the best managers have been in the past. Again, such vehicles are often created when markets are very good but when markets decline they suffer dearly.
Such vehicles are still the norm in the private equity world. Some of the most important privately-held options for private investors are:
- Feeder funds
- Direct funds
- Funds of funds
- Tailor-made fund portfolios
- Investor clubs
Feeder funds are created by some of the world’s larger banks, which make commitments of several hundreds of millions of dollars or euros in highly saleable private equity (usually buyout) funds using the bank’s balance sheet. They then sell these funds to their private clients, often their high net worth private investors. Fees tend to be steep.
Investing directly in private equity funds is limited to big-ticket players only. Officially, private equity fund managers demand a minimum investment of US$5 - 25 million, which is clearly beyond most private investors’ reach. Only the very large “family offices” have the wherewithal to buy directly into these funds.
Multi-manager private equity investments
Funds of funds are another way of investing in private equity, but they have mostly been the prerogative of institutional investors. Some private banks have created funds of funds for private investors, but they have remained fairly rare and small. Most funds of funds have ended up concentrating on institutional investors rather than private investors.
Tailor-made fund portfolios have been the model used at Pictet and is an approach that has been used more in the US than in Europe. This is probably because, on average, institutions using this model must have a minimum size, and as investors are well aware, things in the US tend to be bigger than in the Old World.
Given a large enough potential group of private equity investors, an investment is made in selecting and analysing the best private equity funds (so-called the due diligence process). A sufficiently large group of investors interested in investing in this fund is then created. An investor pool via a common vehicle will make the financial commitment on behalf of all these investors. The private equity fund then only has to deal with one entity and will have the required volume of over $5 - $25 million. This is a very flexible approach and enables private investors to tailor their private equity portfolios to their own needs. The typical minimum amount per investor per fund is around CHF200,000 - 500,000. Fees tend to be in line with or lower than the fees charged by funds of funds with the added benefit of creating a unique portfolio suited to the individual, private investor.
These can be very unstructured, whereby there is a loose agreement, but no obligation, to conduct individual transactions together. Sometimes these clubs work well, sometimes they do not. As always, the quality of the partners chosen to go into business with is crucial. One of the investors must take the lead in analysis, negotiations and post-investment management. Fee levels can be highly variable and essentially each member of the club will have to do his own homework. Investor clubs are usually made up of ultra wealthy private investors and family offices.
Things private investors should avoid
As we said before, there is a huge difference between the best and the worst managers in private equity. Private investors, who do not deal in private equity on a daily basis, are not professional private equity investors, and are therefore probably at least as bad as the worst professional private equity managers. They should avoid investing in direct private equity investments. In our experience, private direct investors usually end up in tears. The private equity profession rightly calls such financing rounds the rounds of “friends, family and fools”.
The second thing to avoid as an inexperienced private equity investor, is first-time private equity managers. Our apologies to all first-time teams trying to raise money, but research has demonstrated that on average most first-time managers do not perform well (Journal of Finance August 2005, Steven N. Kaplan – University of Chicago Graduate School of Management & NBER and Antoinette Schoar – Sloan School of Management at MIT & NBER & CEPR).
Finally, in times like these when the private equity market has been doing very well, all kinds of new models and styles are being launched. In private equity, as in other areas, things that appear too good to be true, probably are.
Private equity can be a very interesting part of a private investment portfolio. However, it cannot easily be sold and should be seen as a long-term investment.
It is possible for a private investor to invest successfully in private equity using one of the approaches described herein.
Private equity is not poker and investors should base investment decisions on the same professional care and diversification they would demand for investing in other asset classes.