The Democratization of Private Assets
A Salve for a Fee Starved Fund Management Industry
Making alternative private equity and debt funds available to retail investors is framed as the democratization of private investing, meaning that private asset returns are now accessible for the affluent retail investor.
Looking at private equity reveals a diverse space that encompasses a number of different investment styles and structures. Wider accessibility beyond institutional investors also reflects a necessity given the reduction in economic participation in public equity markets.
Popularized by the Yale Model pioneered by David Swenson in the mid 1980s, and according to AQR’s Antti Ilmanen, private investors gained as much as 3% above public investors when the Yale Model was initiated, but as of today the premium is barely 1.0%. The best days for private are likely long gone despite the potential for greater participation.
Before we assess whether this is the time to bring private equity to the retail investor, it is worth understanding why private equity and other alternatives (meaning not public equity and fixed income securities) have grown to be a large share of the institutional investor asset mix.
The institutional investor preference for private equity in particular is at first strategic. Allocations are driven by higher expected returns and lower volatility of returns ( the latter interpreted to mean both lower risk of loss and a better portfolio diversification benefit.)
Many institutional investors also believe that they have better information on private companies from fund participation, information that enables them to better manage risk, compared to the information available on public companies listed on public markets.
The private returns come from the dividends generated by the investment, the expected growth premium over a public investment, any multiple expansion and leverage through the use of debt. The generate the extra risk premium, the capital is locked-up for a period of time which is necessary for the manager to meet these return expectations. From this emerges the liquidity premium paid to the investor.
The share of illiquid investments in institutional investor portfolios took off following the 2008-2009 financial crisis as central banks rates fell close to zero, dragging down risk-free fixed income yields to levels far below most investors hurdle rates. This caused an asset allocation push from cash to find higher returns for an acceptable risk of loss. Hence the desire for private equity, real estate and infrastructure.
Private investments require that funds be invested for up to and sometimes exceeding ten years, making them relatively illiquid. If investors want their capital back before the fund’s maturity, they must sell their stake at a substantial discount. And in times of financial stress, the discount can be significant. So to avoid a forced sale, investors hold cash to meet other investment management needs – or they should. Anecdotal evidence suggests that institutional inflows to private equity have declined, leading funds to exit positions to return capital to investors through sales to secondaries which may demand a discount of up to 30% of the current assigned value.
Given the lock-up, most institutional investors hold liquidity reserves and have robust liquidity management policies and processes. When an investor sells a public equity investment to buy a private equity stake, the investor may have to sell -- for example-- $1.05 of public equities for every dollar of private investment, holding 5% back as a cash reserve. Entry into private equity means that the investment must both beat the public equity risk premium and overcome the drag from cash. Finally, investors also want to hold cash to prevent a forced sale of private assets to avoid being insolvent because they are illiquid.
What about retail?
The motivation to accumulate private equity exposure, or private credit and infrastructure exposure, is to boost returns to secure future value goals. While defined benefit pension funds with long investment horizons are ideal private investors, and have the ability to manage illiquid holdings and recover from losses, are retail investors so equipped?
The economic risk in a private equity portfolio is the same as investing in the public portfolio, and the risk remains primarily beta or market. But, there are many financial risks to private asset holdings beyond the exposure to common economic factors. And, potential retail investors need to review whether they are equipped to manage these risks.
Even for sophisticated institutional investors, the illiquidity risk is substantial. Many defined benefit pension plans are aging, where the proportion of retired members now exceeds active members placing them in a net contribution deficit. This means they must provide for an even greater measure of cash when they invest in illiquid private assets because their ability to recover from any loss is reduced. They want to avoid being forced sellers at the worst time to meet benefits.
Many plans would have been in a difficult spot in the 2008-2009 crisis, but central banks came to the rescue by providing generous liquidity support. This cut short the liquidation cycle, but the benefits were not distributed equally. And, the resulting consolidation of losses – that took many years to distribute and absorb -- meant that official rates were kept at 25 bps for some eight to fifteen years depending on the jurisdiction.
Many plans were forced to take more risk when they should have been taking less risk to male up lost ground. Any plans that had overallocated to illiquid assets suffered an even greater measure of pain. It is best to manage liquidity yourself than rely on the official sector to do it, especially in the current chaotic policy environment.
Accidents do happen – even to sophisticated institutional investors
Many investors are subject to information asymmetries, where one party to a transaction has an information advantage over the other. While investors feel that they have a better sense of the risk they are taking in private equity, the potential for adverse selection remains (as the manager or general partner GP typically has an information advantage over the limited partner LP.)
This is best animated by the industry term “blind pool risk“ where the investor, the LP has committed capital that has yet to be invested by the GP in an underlying portfolio. Only after the investment has occurred can the LP begin to understand and manage the risk of the emerging portfolio.
Once the portfolio has been built, investors are give a valuation on the portfolio holdings, and one should not confuse the GP determined valuation with a valuation determined by an observable market price (mark-to-market.) (Often funds will transfer holdings between fund vintages in the same fund family at non-market prices.)
Private equity also has lower disclosure standards and requirements compared to investment in public markets. Despite the assumed information edge of private versus public market investments, there is a degree of valuation uncertainty in the private space because of the quarterly lag in financial disclosure. A lot can happen in three months.
Even big institutional investors can suffer significant losses when valuations are uncertain. Investment giant Blackrock is one of the most sophisticated asset managers in the world, and it forfeited $600 billion from its controlling position in alacrity solutions, an insurance claims manager. Benjamin Shefflin observed “that if sophisticated institutional investors can suffer losses because private market assets are hard to value what chance do retail investors have in private markets?“
In addition to liquidity and valuation issues, the apparent reduction in return volatility and the enhanced diversification benefit this confers is less than meets the eye. Because the volatility observed is not market determined, we can be less sure it is an accurate representation of risk of loss. And, volatility merely defines a range of possible returns. It is not the same as the risk of loss, sometimes from which an asset never recovers as Blackrock experienced. And if the volatility is not representative of the risk, then is the assumed gain in the portfolio diversification benefit real? Most likely not.
Mixing assets that are valued (often by the GP managers themselves subject to some external validation) with those based on observable market price can lead to a false sense of risk and thus potentially inadequate risk management. In fact, in choosing an optimal portfolio in mean variance space often results in models over allocating to private alternative assets at the expense of public assets because of the apparent reduction in return volatility.
What factor risk assessment says
Using a factor-based approach to risk assessment, a recent benchmark study by GARP-APTimum of the top twenty-five US public pension plans looked at the resilience of these plans to adverse economic and financial shocks.
In the past ten years, the top funds returned about 8% annually on a diversified asset mix that included a weighted average alternative holding equal to one third of the assets. While the authors noted that this asset shift was appropriate to the lower for longer interest rate period studied, the funds remain exposed to concentration and liquidity risks.
Applying a factor-based approach, the study found that portfolios are dominated by equity risk, accounting for 85% of total risk of loss! This should not be a surprise given the positive return correlation that is created by the common exposure of private and public assets to the same economic return drivers.
The GARP-APTimum study shows that the assumed volatility and superior diversification benefit expected of private assets is something of a mirage. While pension plans do have a long investment horizon, and most have sufficient resources to ride out such shocks, retain investors are much less aware of the risks and – depending on their level of wealth and cash holdings – less able to ride them out.
Let the Buyer Beware
Private equity returns are now available to investors. Here in Canada investors can access, for example, the Mackenzie Northleaf Private Equity Fund either as a series F for a fee of 1.65% or a series A fee of 2.65%.
The fund, offered to accredited investors, invests about 75% of the fund’s NAV in the Northleaf funds, and the remaining balance in a private equity replication strategy which also acts as a liquidity buffer. The fund offers quarterly liquidity of 5%. Impressively, the fund has returned an annualized 26% since its 2022 inception.
The fund information document, written for investment advisers, shows returns as net of fees, including the “material fees and expenses” charged by Northleaf. The fund report does not present a volatility nor does it show drawdowns. That said, the funds are gated – meaning that withdrawals in extreme circumstances can be blocked – to give the managers time to recover any lost value.
Oxford University Professor Ludovic Phalippou[1] argues that private equity returns – after fees – do not offer any substantial return advantage to public markets. He and others argue that investors are better off, after adjusting for fees and risk, investing in the Russel 2000 for which low fee ETF’s are available. Many of Canada’s big pension plans know this, building large internal private equity management teams in order to internalize management at lower cost and to manage the risk themselves. This would be beyond the resources of most retail investors.
Retail investors now have access to investment returns that have traditionally been reserved for institutional investors and those with a high net worth. However, they need to question whether the fees they pay for exposure to illiquid private equity exposure and other illiquid assets is worth the liquidity lock up given that risk factor analysis suggests private assets are equally as prone to drawdowns as a cheap equity ETF.
Most passive ETFs charge barely six basis points for public market exposure, and many actively managed ETF’s that begin to approach private equity returns and risk do so often for less than 100 basis points compared to the hefty fees charged for the fund structures now offered to retail.
Retail investors should also be wary of providing liquidity to institutional investors at a stage in the cycle where liquidity is hard to come by. Secondary funds do this, and they are experienced sophisticated managers.
At a minimum, retail investors need to think about providing for the risks of this asset class in the same way that institutional investors do.
Cash is king for a reason: it is most valuable at a time when it is most scarce.
[1] Private Equity” A Reality Check.