Private Equity: Greater Returns, Greater Risks

Fidelity added private equity funds to its institutional platform as a result of advisor demand following stellar returns, but there are other factors to consider

Two years ago when asked in an interview on CNBC whether private equity was good for individual investors, Investure CEO Alice Handy said,  “I understand why the industry would want to be in 401(K)s [but] it’s sort of crazy for the average investor.” She went on to point out that the illiquidity in private equity funds, where lockups can run as long as 10 years, high fees and lack of transparency and regulation.

Despite these limitations, private equity funds as an asset class have had double-digit gains for years. Large institutions, very wealthy investors and even public pension funds have invested in these products for years, reaping returns that aren’t seen in any other asset class except maybe venture capital funds.

Cambridge Associates’ U.S. Private Equity Index shows that while most major stock indexes were down 2% to 7% through the end of the third quarter 2015, the private equity index was up 5%, despite being slightly down that quarter. Its longer term gains were 14.3% for three years and 11.5% for 10 years compared to 12.4% and 6.8%, respectively for the S&P 500.

So when Fidelity announced in late April that its institutional division would expand its alternative investment platform to include private equity funds, it was a sign of the times. Private equity funds are now accessible to clients with a minimum of $100,000, according to Fidelity.

“We’ve heard from the advisors we work with that they were looking for an efficient and streamlined way to provide their clients with access to private equity products, says Gary Gallagher, senior vice president of investment products at Fidelity Institutional. “So expanding our platform to include those products was a natural progression and something that’s been in the works for over a year.”

The firm added this access through three intermediaries: iCapital Network, CAIS and Goldman Sachs Asset Management. Each brings with them an expertise of vetting and selecting investment managers, especially private equity managers.

CAIS, which uses Mercer to perform due diligence, applies its own “commercial overlay” to select from Mercer’s recommendations, says Matthew C. Brown, CAIS founder and CEO.  He points out when asked about the risk of private equity to the public, “This isn’t Fidelity.com, this isn’t the retail business. Fidelity is expanding its institutional services, which is for professional advisors, people who are trained, licensed intermediaries. That’s an important distinction.”

But has the stellar performance of private equity over other funds in a tightening market masked some of the issues even advocates like Handy mentions, such as lockup risk, benchmarking and transparency?

“There’s really no reason why investors or clients need to have all their capital liquid all the time,” Brown says, providing as an example purchasing a house that is largely an illiquid investment.  He adds there are short-term lockup period funds, as short as one year, noting the lockup time depends on the fund’s strategy.

Lawrence Calcano, managing partner at iCapital Network, says that lockup periods associated with PE funds “are one of the largest issues that people have to grapple with before investing. But stepping back, there’s a real reason for the lockup periods…. For example, in the case of a buyout, the process of improving value in the underlying portfolio company takes time. If near- term liquidity is important to you, then private equity is not the asset class for you.”

In 2012, TowersWatson published a study on Private Equity Benchmarking and provided recommendations on how to benchmark these funds, including:

  • investors/allocators should change a benchmark according to a fund’s implementation and goal
  • managers should be  matched against their goals and interests
  • both long and short term measures should apply
  • benchmarks should “incorporate a balanced scorecard approach to ensure a more holistic view of both qualitative and quantitative factors affecting risk and return”

Although firms such as iCapital use Cambridge Associates’ PE Benchmark to view the overall private equity returns in the aggregate -- the benchmark is derived from performance data compiled for funds that represent the majority of institutional capital raised by private equity partnerships --  the firm drills deeper when performing due diligence on private equity funds, both before and after selection, Calcano says.

“We look at absolute returns, as well as comparisons to appropriate benchmarks that vary by type of fund,” Calcano says. That means comparing equity managers against their peers who invest using the same strategy. The focus of his firm, iCapital Network, is on selecting mainly first quartile managers.

If iCapital Network analysts are looking at a buyout fund, for example, it might compare it to the Russell 2000 or S&P 500. They dig into the details of the fund, and determine if returns were due to financial engineering or fundamental improvement in the underlying portfolio companies (which is preferable). Then they use that information write a report that is provided on their platform (and Fidelity platform) so advisors can make educated choices for portfolios, Calcano says.

Does he believe the new investment in private equity funds might dilute the asset class’ long-time stellar returns?

“Private equity has been around a long time as an asset class, and historically is an asset class that has largely only been available to institutions and the absolute wealthiest of individuals,”says Calcano.  “Part of what we’re really trying to do is democratize the asset class, so that qualified investors will have a chance to invest thoughtfully in it just like institutions do.”

 --Related on ThinkAdvisor:

Page 1 of 2
Single page view Reprints Discuss this story
We welcome your thoughts. Please allow time for your contribution to be approved and posted. Thank you.

Most Recent Videos

Video Library ››