In today's persistent low-yield environment, the challenge remains for advisers to identify opportunities to enhance portfolio returns for clients. Going forward, the solution may not come from public equities. The equity investment has been a strong performer since the market trough of the global financial crisis, but if equities run out of steam, where do investors turn?
Advisers know they need to look further afield for yield and alpha. Use of alternative assets such as real estate, infrastructure and hedge funds is growing, and with it so are new, innovative approaches to expand the use of private equity within investor portfolios.
Track record
Private equity has been no stranger to institutional investors.
The Private Equity Growth Capital Council (PEGCC) reported that as of June 30, 2014 returns from private equity funds (net of fees) beat the S&P 500 (including dividends) for the 10-year horizon by 6.5 percentage points. Returns to U.S. public pension funds from their private equity investments for the 10-year horizon also beat the S&P 500 by 5.9%, PEGCC research shows. This return premium can make quite a difference when compounded over a multi-year period.
The variability of returns delivered by different managers can be significant in any investment class, and private equity is no different in that respect. Indeed, the dispersion of returns between the best and worst private equity funds was 14.5% in the period between 1992 and 2012, according to
industry data provider Preqin.
While a typical U.S. public pension plan allocates around 9% of its assets to private equity, other groups — private pensions, smaller institutions and private investors — have been less allocated. But
the latest research from McKinsey finds evidence of a shift.
In the period 2005-2013, global assets under management in retail alternatives ballooned from $800 billion to $2 trillion, a compound annual growth rate of 12.6%.
McKinsey reports that inflows into traditional alternative investments (despite excluding retail alternatives) have grown twice as fast as traditional investments since 2005. The firm cites disillusionment with traditional asset classes and products, more sophisticated portfolio construction and tighter focus on specific investment outcomes as key drivers for the growth in inflows into alternative assets. The McKinsey research concludes that the retail segment will be a primary driver of alternatives growth, particularly in the U.S.
(Related read: Alternatives earning their keep in 2015)
Despite that apparent trend, many advisers are likely to first look at the traditional mutual fund universe for investment options. The U.S mutual fund industry has been historically dominant in private investor portfolios. U.S investors account for $16 trillion of assets in mutual funds as of February 2015
according to the Investment Company Institute. By contrast, the U.S private equity buyout market is a minnow with approximately $1.6 trillion in assets under management, according to
data from Thomson Reuters.
Size of the private equity market hasn't been the only issue for investors. The principal reasons why private investors have generally not invested in private equity include high entry barriers -- the typical traditional minimum investment threshold for a private equity fund has been $10 million. There has also been limited awareness and understanding about what private equity actually is as an asset class. The securities laws have also stipulated that managers of private equity funds draw capital only from accredited investors.
Finally, even if those criteria are met, access to private equity has traditionally taken the form of a closed-ended limited partnership, a generally unfamiliar structure to an investor more used to mutual funds.
Evolution is afoot
Managers with extensive experience of investing in private markets have been exploring
how to bring alternative asset classes like private equity to structures such as 401(k) plans and IRA accounts.
In addition, vehicles with much lower investment minimums and eligibility requirements are already here. These include feeder funds into private equity funds, non-listed SEC-registered funds, listed private equity vehicles, and business development companies (BDCs). Advisers should expect to see more of these solutions entering the market.
When looking at options, investors should always consider their overall goals — whether they are looking to preserve capital or generate income, and whether they are seeking a growth-oriented or a balanced strategy. Such options may include (but are not limited to) working with a multi-manager.
A private equity multi-manager, or fund of funds, approach generally provides broadly diversified exposure to tens of underlying private equity funds, and potentially hundreds of underlying companies, thus potentially mitigating the risk of loss from any one manager or company. They tend to be offered to investors with a predetermined investment and allocation strategy.
While fund of funds typically charge a fee on top of underlying private equity fund managers' fees, this provides for a “one-stop-shop” approach for investors in terms of manager due diligence and selection, portfolio implementation, reporting, governance and operational management. Fund of funds can provide a simpler stepping-stone into private equity for new investors or those who feel less equipped to manage a portfolio.
Sheldon Chang is a partner and head of private wealth at global private investment manager Pantheon.
