Private equity represents the last resort for weary investors seeking superior, better-than- market returns in today’s bubbling bull market. High prices and low fixed-income yields are so crippling and scary that they must assume high risk through derivatives or structured financial products. Warren Buffett remarked that he can’t find any cheap stocks. Unfortunately, private equity is the most difficult asset class where individual investors can achieve success.
Portfolios need to diversify beyond passive assets, such as exchange-traded funds (ETFs) and other index-tracking vehicles. And everyone wants enhanced returns. Rabid day traders empowered by an army of robotic internet trading platforms moving in and out of liquid markets need to balance their portfolio with long-term investments. Since the 2008 global financial crisis, participating in private-equity and venture-capital funds that invest in technology start-ups is a risky stab at achieving absolute returns – that is, returns that aren’t correlated or tied to passive indices. The ultimate goal for a fund is to find the next Facebook, for example, and make 100 times your original investment in three to five years.
Easier said than done. Harvesting the illiquidity premium – the “private” aspect of unlisted investments – is one of the most difficult challenges in finance. Private equity represents the most labour-intensive investment- management exercise. It requires skills beyond finance to seed, guide and then harvest returns through an IPO or sale or merger.
Investors are highly dependent upon their asset managers, who must marshal a wide array of talents, from finance and technology to determine industry trends. It’s much more daunting than for traditional mutual-fund managers. These alternative assets cover a wide range of both obscure and familiar strategies, from hedge funds to private equity and venture capital. Indeed, the strategies of this asset class can be as obscure as betting on the outcome of merger and acquisition situations, technology start-ups, environmental lawsuits, bankruptcies and restructurings. Deciding which management team can create a successful portfolio in five years is an almost impossible task. Uncertainty of outcome means private equity is also the most expensive asset class, charging around 2 percent per year and a 20 percent incentive fee.
Unless you’re active, knowledgeable and connected in the private-equity business, you’re highly dependent on recommendations from your private banker and wealth manager. If you aren’t a valued ultra-high-net-worth investor, you can’t access top venture-capital or private- equity funds. The demand for proven, successful investment managers is so high that they can pick and choose whose money they accept. Top funds usually turn away investors.
Finding, cultivating and developing the right team and individuals is as hard as assembling a cast for an award- winning movie. It’s not as simple as other areas of banking, where any MBA can process loans. And teams often fall apart for a variety of reasons, leaving their investors with a dissolute management. Translating and visualising the next trend in technology or product development requires both wild creativity and disciplined skill sets. If success were as easy as hiring people with corporate backgrounds, then every successful fund would be staffed by former IBM or Hewlett-Packard employees.
Today’s highly regulated banks are limited as to which private-equity firms qualify to be marketed to their private banking clients. Most of the offerings comprise firms with long track records and established management teams.
No wealth manager wants to be sued for introducing clients into a new fund that suddenly fails. Yet first-time funds featuring people who’ve previously worked together can spin great returns in an untested field.
Research studies have objectively shown that the best private-equity returns across sectors are usually generated by investment bankers instead of management consultants. About 70 percent of private equity returns can be attributed to the entry or buying price of an asset followed by its IPO or sales exit. Investment bankers are trained and experienced at timing markets and negotiating favourable terms. So, believe it or not, “buying low and selling high” is more important than discovering the “new, new thing”.
For example, a common theme in the market over the last several years was investing in funds that developed student housing in cities with numerous colleges and universities. It’s been heavily sold to retail and high-net- worth clients. Unfortunately, units of some of these funds have failed to perform, making them difficult to liquidate. The manager can’t produce enough cash to satisfy unit holders who want to sell. Too many sellers seek an exit, all at the wrong time. And herein lies the investment dilemma for private-equity investors – you need to cope with the lack of liquidity and hope that your manager can generate enough returns to justify this risk.
Investing in publicly listed, private-equity management firms like Softbank or Blackstone is an alternative that offers liquidity. But you risk high market valuations and should carefully study that their management teams’ performance incentives are aligned with outside investors. As in any risky endeavour, the key is discerning what you want and what you want to believe.