The Temptations Of Private Equity

Stumbling unicorns haven’t shaken the wealthy’s faith in private equity, but are its best years behind it?

The private equity industry endured some high-profile debacles in 2019. Shared-space empire WeWork crashed from a presumed valuation near $50 billion to near-bankruptcy as it prepared an initial public offering. Ride-share champion Uber lost one-third of its value post-IPO. These misfires tarnished the aura around the so-called unicorns (pre-IPO firms valued at more than $1 billion) that private equity funds were counting on for fat cash-outs.

But none of that has squelched high net-worth individuals’ mounting enthusiasm for the asset class, says Michael Crook, head of Americas Investment Strategy at UBS Global Wealth Management. “We’re seeing clients’ interest increase over time,” he says. “Most private equity companies are firms you’ve never heard of, and quite a few of them have positive cash flow.”

Private equity funds, which have expanded sevenfold since 2000 to some $3.5 trillion globally, are returning the love, eager to expand their capital pool beyond traditional institutional investors. The biggest of them, Blackstone, reports raising 14% of its $560 billion war chest from individuals and aiming for “multiples of that.”  The courtship opens a lucrative middleman role for private banks between their wealthy charges and the broad, bewildering universe of private equity offerings. “A lot of the private equity firms are trying to get into the individual space, but that’s easier said than done because the audience is so dispersed,” says Dan O’Donnell, global head of Investment Management Alternatives at Citi Private Bank. “We’ve been doing this for hundreds of years.”

So, everybody wins as private wealth funnels into private equity? Maybe. The investment case for private equity leans on two firm premises and one big, wobbly one. The solid arguments are: one, it’s a worthy alternative for investors who are earning less from traditional fixed income as bond yields approach sub-zero; and two, the supply of public equities has shrunk. The roster of listed companies in the US, the world’s biggest market by far, has contracted by nearly half this century.

But the key argument for private equity is also the shakiest: that it will return more to investors over time. The best numbers out there indicate an average 2%-a-year advantage over publicly traded stocks, UBS’ Crook says. That would indeed add up to big bucks quickly in a multimillion-dollar portfolio. There’s an important caveat, though: Because private equity funds stay locked up for 7 to 10 years, statistics gaze far back in time markets-wise. “The data show outperformance, but the data only show the first part of the last decade,” Crook notes. The closer you look to the present, the lower the payoff, as more funds chase the same deals and buy-in prices rise from a nadir in 2009. “Absolute returns for the industry have come down over past decade. That’s an obvious statement,” O’Donnell says.

Public equities are subject to the same mathematics of diminishing returns as current valuations rise, he and Crook argue. Therefore, private equity can maintain its relative lead. But that ignores the heavy weight of fees in private equity, counters Ludovic Phalippou, a professor at Oxford’s Said Business School who studied the industry for 20 years. A typical private equity fund eats up 5% to 6% a year in fees, most of them fixed charges for “monitoring,” “transactions” and the like. These become a profit crusher as gross returns contract. “In the past they might have generated 18% growth and 12% net,” Phalippou explains. “Now, if growth is 12%, that’s going to leave 7% net.”

Even historically, the case for private over public equity is shaky, Phalippou contends. “People pick their benchmarks and time periods to compare,” he says. “But over time, private equity and US stocks have delivered the same average—around 10% a year.”

A more localized disagreement focuses on how rich you need to be to dabble in private equity. Michael Crook recommends this illiquid asset class only for clients at the higher end of high net worth—$10 million or more in liquid investable assets. But a posse of fintech startups are targeting a mass-affluent public that might not even get through the private-banking door at a Citi or UBS. Berlin-based Moonfare sets its ante at 100,000 euros ($109,147), which clients typically phase in over four years and can spread among 10 or so funds offered on the platform, says co-founder Steffen Pauls, who worked at buyout powerhouse KKR before striking out on his own. Moonfare has collected €250 million since its launch in 2018. “This is the democratization of private equity,” he declares. “There are lots of people out there who can afford to put 20% of their net worth into these funds, and the Blackstones and KKRs of this world have discovered they need them.”

One point of general agreement is that private equity investments require diversification no less than public securities, and that’s where wealth managers come in. While the industry may cultivate a wizard-like, invest-in-anything image, its offerings in fact vary across a wide range of industries and geographies–from fintech to infrastructure, Latin America to Asia. Allocating too many resources to any one of them entails similar risk to betting the farm on a single stock. It’s also critical that investors stagger their inputs to private equity to ensure different exit schedules, or “vintages.” Otherwise, the full investment could mature during the next financial crisis, a la 2001 or 2009. 

But unlike listed mutual funds and ETFs, which offer detailed compositions and performance data at a click, the plethora of private equity funds is next to impossible for an individual investor to navigate themselves. That spells a great opportunity for private bankers to add value back to investment services that clients have been taking into their own hands. “If you want 20% of your portfolio in US equities, we can make that happen this afternoon,” Michael Crook says. “Private equity is more like a program. You need to make consistent commitments over a number of years and build up slowly.”

So, are private equity returns really worth sacrificing liquidity and enduring the big bites taken out by intermediaries? The overriding opinion on this question, rich individuals seem to say, is yes. “The noise from the fall is looking like a bit of a non-event,” says O’Donnell of Citi, referring to the failure WeWork and other unicorns. “We saw renewed appetite this year, and it is definitely a global appetite.”

If private equity returns are sagging, investors expect the same from public equity going forward, from its current peak. A standard forecast is 5% to 7% from stocks during the 2020s, a figure private equity can likely still beat, Crook says. Illiquidity can also be a virtue for investors who can afford it, he points out, smoothing out portfolio performance and decreasing the perilous temptation to sell in a downturn. “You get equity-like exposure without the day-to-day volatility of the markets,” he says.

Private equity is also adjusting its own offerings for leaner times, says O’Donnell, mixing in more convertible-debt strategies with the traditional debt-fueled buyouts and punts on promising startups. “Special situations structures, industries technology and health care, or geographies like China, can still potentially generate double-digit returns even if lower-hanging fruit has been plucked,” he says.

The bottom line: Private bankers can responsibly nudge clients to try some private equity as part of a diversified, long-term portfolio. But take heed if you’re thinking of trying it at home.