With public markets at record highs, is it a good time to consider private investments for better long-term returns?
Private equity has been around for more than 30 years but is still relatively unknown to most retail investors. It has evolved from being an asset class for institutions and high-net-worth investors to one that is increasingly available through publicly traded funds. Some wealth management firms have also started to offer “funds of funds” to allow their clients to diversify across a range of individual fund managers, albeit through a “retail” investment structure.
However, private equity investing is often not part of the typical conversation between retail financial advisers and their clients. This might be about to change. With increasing fee disclosure and accountability, more people are choosing diversified, hassle-free index funds for their retirement plans. The management fees on these passive funds have declined precipitously, to as low as 0.03% from between 1% and 3%. As investors have rushed into these funds in record numbers, they have concurrently exited actively managed funds.
Most actively managed funds have been unable to beat passive funds after subtracting their higher fees. The problem is highlighted when returns are low, because it feels more expensive paying 2% in fees when total returns are only 6%, compared with when stock returns exceed double digits, and when the long-term “risk-free” return from fixed-income instruments like long bonds might be yielding only 2% to 3%. The scarcity of sustainable returns from traditional stocks and bonds is forcing wealth managers to look for alternative assets to offer their clients.
Private equity and other alternative assets could be options to consider for retail investors with a long-term horizon who want to generate higher risk-adjusted returns to supplement a core passive investment strategy.
Private equity investments have performed well on average over the last 10 and 20 years, beating public markets by a decent margin. .
Private equity as an asset class generally includes buy-out and growth investments in private companies, as well as mezzanine and high-yield corporate debt. It is usually done through a fund structure, where the investment is illiquid until the fund fully deploys and realizes its investments, which can mean your money is tied up for between five and 10 years. To compensate for the illiquidity, one expects a higher rate of return; however, if you are saving for retirement or estate planning with a long-term horizon, the liquidity premium really does not matter that much.
As you are entrusting your capital to fund managers, the key decision is choosing the fund to invest in. The fund managers charge a fee, typically 2%, plus a percentage of the upside over a hurdle rate of return (usually 20% if they exceed returns of 8% per annum).
We invest our own and our clients’ capital; however, we believe a fund is not an optimal structure. We believe fund structures inherently possess and create significant misalignment of interest between investors and managers. For example, we do not want to charge investors fees on their capital that is not yet deployed, nor do we support the perverse incentives to dive into investments quickly just to charge fees. Furthermore, we do not want to be forced to sell great businesses just because the fund life is reaching its end. Indeed, we share the same views of some “superinvestors” like Warren Buffett in our desire to hold on to our best investments for as long as we can. For the best investments, as Buffett says, “our favourite holding period is forever,” because redeploying capital efficiently is a difficult task.
With interest rates set to rise, combined with the withdrawal of quantitative easing, investors need to be wary of overpaying indirectly through their fund managers. Select, innovative small and medium-sized companies that are out of the spotlight of most private equity and strategic investors can offer the best margin of safety for valuation, and, with the right management, can be expanded over the long run into international and adjacent markets. •
Robert Napoli ([email protected]) is principal and managing director of Promerita Capital Partners, a private equity and mezzanine financing business that is a member company of Promerita Group. He is also president of ACG British Columbia.
