From the June 2017 issue of Investment Advisor • Subscribe!

The Mainstreaming of Private Equity, Phase II

A new secondary market could soothe lingering memories of fire sales in 2008

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Private equity's appeal has been limited by its illiquidity. Private equity's appeal has been limited by its illiquidity.

As the number of publicly traded companies is shrinking, the appeal of private equity is growing. At the end of 2016, private equity funds held a record high $2.49 trillion assets under management, including $820 million in “dry powder,” or money available for new opportunities, according to Preqin, the London-based research firm.

Despite its growing appeal, private equity has always been limited by illiquidity. Memories are still fresh of 2008, when major university endowments and other institutional investors offered billions of dollars in private equity holdings for sale at big discounts in the secondary markets. The fear of fire sales lingers.

Those worries could ease if a new secondary market auction platform by Nasdaq Private Market (with regulatory relief granted by an SEC order) succeeds in what the exchange describes as an effort to streamline “the administrative burden of providing shareholder liquidity through an end-to-end technology solution.”

Here's why I think the illiquidity issue is getting traction and why Nasdaq's move is well-timed. More retail investors are gaining access to private equity and other illiquid assets through select ’40 Act funds, sometimes referred to as “interval funds.” You could call this Phase I of mainstreaming private equity. These funds are closed-end SEC-registered investment funds but are not listed on any exchange. Thus, they can be offered to a wider audience (of suitable and qualified investors) than traditional private equity funds, and often at much lower minimums.

But there is a wrinkle to interval funds, which both helps and hurts investors. Unlike regular or even “liquid alts” mutual funds, which offer daily redemptions at net asset value, investors in interval funds can only redeem shares at set times and in limited amounts. That may alleviate the danger of a stampede of investors in the midst of a downturn, but still leaves the liquidity issue. Investors could turn to the one of some 485 secondary marketers, as happened in 2016 when volume in the private equity secondary market reached its near record peak, but it can be a time-consuming process, and the discounts can be big.

Alts Go Mainstream

The new platform, NPM Alternatives, is taking a different approach. Instead of a one-off sale, NPM Alternatives will aggregate buyers and sellers to create a more open and informed market. Whether it's an individual who wants to sell a $150,000 commitment or an institutional investor looking to buy a $10 million position, they can all meet in the same place to participate in an auction.

If it succeeds, I believe NPM Alternatives could be Phase II of private equity mainstreaming. The mechanism may further help alleviate a cascade of redemptions, since the transactions are in the secondary market and don't drain capital from a fund.

In my opinion, the mechanism will also preserve one of the countervailing virtues of illiquidity — long lock-up periods, which give private equity managers the latitude and flexibility to pick and choose among the roughly 6 million U.S. private companies (i.e., those with more than one employee) available for investment, with ample time for their diligence to bear fruit.

Unlike investing in a public company, where passive shareholders can only hope executives will act in their best interest, private equity managers are hands-on investors. They are able to buy, control and improve the company. They are typically long-term investors, another potential benefit of illiquidity. The same virtue applies to the exit from an investment. Illiquidity gives the manager a chance to wait for the best moment to sell out, which is especially important when selling a private company.

Illiquidity, together with the chance to find and remake inefficient companies, underpin private equity's impressive 13.22% annual return over the past 25 years, according to Cambridge Associates. Of course, there's no guarantee that it can sustain this performance. Only investors who can afford complete losses should consider private equity.

Nasdaq's “aspiration is to modernize these alternative assets through technology, structure and process,” as Eric Folkemer, the head of Nasdaq Private Market, told one of my colleagues. “Selling private equity holdings into the secondary market is recurring behavior. ... It's here to stay.”

Those of us in alternative investing will be watching with interest.

--- Read Aflac Finally Follows Peers in Placing Wager on Private Equity on ThinkAdvisor.

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