Private equity begins to entice ordinary investors

Beyond the public markets, where company share prices blink on trading screens on a second-by-second basis, there is a world of private companies and a $3.8tn industry of fund managers claiming a special set of skills for extracting value from them. Investors able to take a long-term view, who are seeking returns potentially higher and uncorrelated to the equity markets, could find private equity an intriguing, if risky, alternative.

It is not an easy asset class to invest in, however, unless you are a giant pension fund or an elite university endowment of the kind that pioneered private equity investing in the 1980s. Only the very wealthiest can afford the big sums demanded for direct access to private equity funds run by famous names such as Blackstone, Apollo and Carlyle, which may require a minimum investment of $1m, $5m or more — and fees are high.

A few options for getting private equity exposure do exist in the public markets, but most likely, investment would be offered through a fund of funds run by a wealth management firm.

Private equity divides into two camps: on one side are corporate turnround specialists and financial engineers who buy out companies from the public markets, with a view to improving their returns over five to seven years; on the other side are venture capital firms that provide funding to new and fast-growing businesses, in return for an equity stake. The distinction is somewhat analogous to the division between value stocks and growth stocks in the public markets — and just like in the public markets, “value” has beaten “growth” over the long run.

Independent industry-wide figures are hard to come by, but there is a growing body of evidence that private equity outperforms the public stock market over time. This is what investment theory would suggest, since investors need to be compensated for the risk of locking up their money in an illiquid asset class. The British Private Equity & Venture Capital Association calculates that, over the decade to 2013, its member funds generated an annual return rate of 15.7 per cent, compared with 8.8 per cent for the FTSE All-Share index. The average obscures a wide range of outcomes, and even well-established firms can have disastrous funds, complicating investors’ selection process.

There is also the question of whether the average outperformance is worth the high fees, which can approach a hedge fund-like “two and 20” structure of a 2 per cent annual management charge levied on the assets under management plus 20 per cent of the fund’s profits. In recent years, some of the earliest institutional investors in private equity have been paring their exposure to the asset class, or cutting the number of managers they deal with in an attempt to get a better deal on fees. The US Securities and Exchange Commission is among the regulators to have targeted unnecessary expenses and hidden fees charged by the industry.

That said, the industry is back on the front foot thanks to the recovery from the financial crisis and a rash of multibillion-dollar “exits”, in which funds have been able to profitably sell long-held investee companies in a stock market flotation. Even venture capital is enjoying a fundraising renaissance amid the clamour to find the next Facebook, Twitter or Uber, though the eye-watering valuations of some tech companies suggest investors should treat this area with extreme caution.

Wealthy investors are increasingly joining institutions in carving out a portion of their portfolio for allocation to private equity. Brokers and wealth managers may offer funds of funds containing slices of anything from half a dozen to several dozen private equity funds, spread across multiple managers and geographical regions and perhaps including a mix of buyout funds and venture capital. Minimum investments vary but are a fraction of those for direct investment. The downside: there will be extra fees layered on by the fund of funds.

Traditional private equity managers such as KKR have begun looking at ways to cut out the middleman and offer opportunities for individuals to invest at much lower minimums, perhaps all the way down to just $10,000.

Investors who want to make an even smaller commitment, and who are cautious about locking up their money, could invest in the shares of publicly listed private equity managers, which do well when performance fee income is streaming in. The UK’s 3i Group has been a FTSE 100 index stalwart for two decades, while in the US, a wave of private equity manager flotations was led by Blackstone in 2007.

Want to buy a selection? There are several exchange traded funds tracking the quoted private equity management sector as a whole, including the PowerShares Global Listed Private Equity Portfolio listed in New York. One caveat is that many of the biggest private equity firms are branching out into hedge funds, property and even traditional asset management activities, making them a less-than-perfect proxy for private equity as an asset class — even though they may be becoming a safer investment.