The Asian currency crisis ushered in a new era in the practice of portfolio management. This event signaled a warning to many investors who were previously unaware that the global economy had matured to the point where activities across the globe could impact their domestic holdings. Joost Driessen and Luc Laeven concluded in their study of a 17-year span ending in 2002 that portfolio exposure to developed international countries offered very large diversification benefits at the beginning of this period, but that these benefits decreased by the end of the period.
The challenge for advisors in today’s low-return environment is to identify asset classes that are uncorrelated to the existing elements within a portfolio, and that can therefore provide the excess return desirable when undertaking the unique risks associated with new asset classes.
Hedge funds and emerging markets are two asset classes that were added to the tool chests of many advisors over the last 10 years. These vehicles became even more mainstream with the advent of a few mutual funds that offered the characteristics of these asset classes to the investing public at large. In the past few years, private equity funds have garnered the spotlight with noteworthy acquisitions of public companies such as Chrysler Corporation, Hertz, and Toys “R” Us.
As with the above examples, private equity can mean the privatizing of a public company to add value, which couldn’t be done as efficiently if the company was left in its former mode. The ownership team that bought Chrysler was able to poach key talented managers from other automakers because they could offer compensation packages that publicly traded companies couldn’t due to shareholder activism. Private equity can also involve the purchase of a division of a larger company to provide the resources and attention needed to create value. It may also involve purchasing a company that is already private, and then offering access to additional capital or talented management with the goal of significant value creation.
The Outperformance Advantage
Private equity advocates point to many reasons why private equity should outperform its public counterparts.
- In a competitive industry, private company management has the advantage of keeping strategic initiatives close to their vests, unlike public companies that are required to disclose investment decisions to their shareholders and the public.
- Analysts and investors have placed great importance on quarterly earnings reports and this has led many managers of public companies to focus on short-term growth to meet those short-term expectations. Managers of private companies can focus on long-term growth to unlock the greatest amount of value.
- Costly governmental regulations imposed on publicly traded companies (such as Sarbanes-Oxley) can be quite expensive and limit the companies’ ability to maximize long-term profits.
- Thomson Venture Economics found that the annualized return for private equity funds over a 10- and 20-year period was 100 and 210 basis points higher, respectively, than the S&P 500. Leibowitz and Bova’s 2004 study concluded that private equity funds had a 0.70 correlation to U.S. equity, negative correlations to government and corporate bonds, and low correlations to other asset classes. A manager that subscribes to Modern Portfolio Theory could use private equity as a tool to lower volatility and increase portfolio return.
Past issues of Investment Advisor have included articles on the trend of advisors investing in private equity. Articles by Michael Fischer in the September 2007 issue titled “Getting In,” and in October 2007, “Behind the Numbers,” detailed the due diligence process for private equity funds.
If you have decided that private equity is the right asset class in which to invest client funds, do you have choices other than investment into private equity funds? Private equity funds have the disadvantage of large fees that in a majority of cases eliminate any alpha produced by the fund manager.
There are three main challenges to be addressed before a direct investment in private equity should be made: illiquidity; adverse selection; and talented management identification.