Private equity chases new investors – your aunt Edna

Private equity is eyeing smaller investors. Image sourced from www.shutterstock.com

Private equity is becoming much less private these days. But it is still not clear who will benefit from this new-found openness and accessibility.

Not so long ago, private equity operated largely outside the attention of the general public; related to the earlier era of “leveraged buyouts” that were eventually condemned for their hubris and greed, but not considered quite as excessive.

In the 2000s, however, after the arrival of multi-billion dollar funds and a few spectacularly high-profile birthday parties, the titans of private equity could no longer remain in the shadows.

When Mitt Romney captured the Republican nomination for President in the spring of 2012, it was difficult to find someone who did not have an opinion about private equity, good or bad. The structure and tax treatment of their profit participation – known colloquially as “carried interest” – was singled out as one of the ways the rich could avoid paying their fair share. Many critics, perhaps wistfully, thought that the era of private equity would come to a close.

Just who should participate?

Private equity not only survived but thrived in the years following the global financial crisis. Today, the question is not whether the financial model underpinning the industry will be viable in years to come, but rather how broadly should participation in private equity be allowed to expand.

Recent reports of a new campaign by Wall Street firms to widen the number and types of investors who have access to private equity funds raises a series of potentially difficult questions. Traditionally these funds have been limited to small numbers of highly sophisticated and experienced individuals. Under the proposed change there is concern whether my Aunt Edna should take some of her life savings out of her 401K and seek her share of the staggeringly high returns that the best private equity funds routinely deliver.

My Aunt Edna is not a “qualified purchaser,” which the SEC has defined as someone with $5 million or more in investments. In fact, she is not even an “accredited investor,” meaning someone who earns at least $200,000 a year. No, Aunt Edna is a typical retail investor who has entrusted her savings to regulated mutual funds and shares that are listed on big stock exchanges like NYSE and Nasdaq.

Why would private equity funds be targeting my Aunt Edna and countless retail investors like her? It’s simple. While their funds have largely done well in the years since 2008, many of their traditional investors – large pension funds, mutual funds and the like – have not fared quite as well. As private equity firms seek continued growth, they must have access to new sources of money and new groups of investors. Hence, their focus on “retailization” and the need to market to the millions of savers and investors who have previously been ignored.

Allure of high returns

For now, products are being constructed to cater to lower and lower tiers of the high net worth crowd. Eventually however the allure of the trillions of dollars stashed away in 401K plans will prove overpowering. What should I say to my Aunt Edna when she eventually calls me ask for my advice?

I will probably explain to her the basic model that private equity generally follows – namely, that they tend to buy sick and damaged companies in need of repair. Often, like the house she and my uncle bought many years ago, they do so with a significant amount of borrowed money in addition to their initial equity. Then I will point out that private equity firms don’t work for free. In addition to whatever fees she will be paying in the “feeder” vehicle that is created for her and people like her, Aunt Edna will have to understand that she will also be paying 2% each year in management fees and she will have to give 20% of any profits with the private equity firms.

Promising more than it delivers

Ultimately, though, I will explain to her that although many of the best private equity funds do exceptionally well for their investors, many funds do not generate the high profits they promise. I will advise her to carefully scrutinize any private equity funds opening their doors to retail investors like her. Are they among the top quartile performers or the bottom quartile? Are the funds reaching out to her because they are expanding beyond the traditional sources of capital that has backed them for many years or because experienced and knowledgeable investors do not think the fund is up to scratch?

The California Public Employees Retirement System attracted attention around the world last month with their sudden announcement that they were exiting from hedge funds. Their investments with private equity, however, still remain in place. In fact, if my Aunt Edna had been a state employee, her monthly retirement checks would have been provided to her courtesy of many private equity funds, since public pensions plans like CalPERS are the largest single investors in this asset class.

Private equity has been with us since the early 1970s, and it is here to stay, at least for another business cycle or two. When my Aunt Edna asks me whether she should invest in private equity, I will have to tell her that if she picks the right fund, she could earn high returns, and if she picks the wrong fund, she could lose some or even all of her money. She will need to do her homework. In that way, at least, it is like every other important investment decision she has been making for years and years.

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