Clear paths emerge for private investors venturing into private equity

The current state of both equity and bond markets is proving to be a cause for concern for high net worth individuals, and those that have the available capital are looking to private equity as a source of reliable returns.

“The investment environment in other, particularly listed, asset classes is a challenging one at present, and as a result investors are looking at private equity, and also more broadly at private markets such as credit strategies, as being increasingly attractive and offering returns which are both better and more stable,” says Richard Clarke-Jervoise, private equity investments manager at London-based Fleming Family & Partners. The firm is a multi-family office, managing around £4bn (€5bn) on behalf of about 50 families.

The rewards on offer are clearly attractive – he claims private equity can offer annual returns of between 10 and 20 per cent depending on which part of the asset class investors choose. But it is also much more stable than sometimes imagined. Private equity has seen just one year of negative performance over the last decade, in 2008, explains Mr Clarke-Jervoise.

Investors believe public markets are acting irrationally at the moment, he adds, amplifying the attraction of private equity. “What is worrying people in the current environment is that they are looking at the stockmarket, which is high despite earnings being relatively flat, while bond yields continue to fall despite everyone talking about rate rises. While there is some correlation with public markets, private equity performance is driven principally by economic fundamentals to a much greater extent.”

Private equity is capable of offering true outperformance versus traditional assets such as public equities and bonds, agrees Charlotte Thorne, founder and partner at investment office Capital Generation Partners, but the disparity of returns is vast.  And so the decision about how best to gain access is vital, and investors must fully understand the pros and cons of the different routes in.

A standard GP/LP (general partner/limited partner) fund structure offers investors the expertise, deal flow and specialism of using professional private equity experts to source and manage assets, she explains, but it comes at a cost, with most funds charging a 2 per cent annual management fee and 20 per cent of returns as a performance fee.

Funds of funds can offer investors a convenient method of gaining diversified exposure to private equity through a range of different strategies and geographies. “The drawback is that investors incur a double layer of fees for the fund of fund and the underlying funds it invests in,” cautions Ms Thorne.

Direct investing often appeals the most to UHNW individuals, who have typically  built up fortunes through business and so the idea of investing in a company comes naturally, plus it avoids the high fees that come with funds.

“However, their experience is not necessarily directly applicable, as they may be dealing with an entirely new industry or sector,” she warns, “while investment banks and institutional investors will have reviewed and rejected various deals before they are even offered to private investors.”

A newer trend for private wealth investors is to seek out direct private equity investments through club deals, says Ms Thorne. “While clubbing together with other wealthy individuals may seem to address some of the justifiable concerns with investing via funds, we believe that this is not the best solution to the problem. Managing a group of investors with different requirements, time horizons and aims, and imposing corporate governance, normally means that a pseudo-GP/LP structure is required anyway.”

Private equity should not be viewed as an asset class, rather a style of investing that offers exposure to a variety of long-equity and debt instruments, she adds. Investors must therefore be aware of any private equity holdings in the context of their overall portfolio to avoid any unintended concentration of assets.

“For example, it is not uncommon in today’s market for larger private equity funds to hold public equities within their portfolios, for example following an investment completing an IPO. So a client portfolio might be exposed to the same company in both its public equity and private equity allocations.”

The ways in which private clients use private equity has undergone a radical shift over the last decade, believes Simon Jennings, head of private equity at HSBC Alternative Investments. In the late 1990s and early this century it was all about getting into the asset class.

“Many private clients viewed private equity as mysterious and difficult to access, and it was really restricted to large institutional investors. Private clients, other than the large family offices, hadn’t really invested in any meaningful way,” he says, explaining how the most common way in was the use of bank-sponsored feeder vehicles which invested into a single fund.

But the financial crisis was a turning point. Some investors chose to stay away from private equity having been disappointed by its performance, while some chose to remain in the feeder structure.

“But there was a different type of client, generally from the upper ends of the client segment, the family offices and the UHNW investors, who said: ‘I haven’t really enjoyed the ride so far and I want something different. I want more visibility, I want to avoid blind pool funds, I want to see something tangible that I can buy. I want to be involved in the investment process and I want to avoid double layers of fees. I’d like quicker distributions back and shorter overall time frames.’”

It took time for the banks to respond, and the new solutions did not appear overnight, but as the demand from clients continued to get louder, their choice of vehicles began to increase, and this coupled with increased visibility has begun to attract new investors into private equity. At the same time, existing investors began to change the way they approached the asset class. Mr Jennings gives family offices as an example.

“The dispersion of returns between the best and the worst of private equity is extremely wide, and you need a lot of skill and experience to pick the winners,” he says.

A family office might not want the cost of building up a team capable of delivering these skills within their organisation, explains Mr Jennings. “For a relatively small part of their overall strategic asset allocation, maybe 10 or 20 per cent at the high end, it is very difficult for these family offices to justify having a team of eight or nine people just focusing on private equity,” he says.

“So there are those who would have used in-house investment teams in the past who are now looking to work with people like us in creating bespoke solutions where they retain an involvement in the investment process.”

No matter which way an investor chooses to access private equity, the asset class remains an illiquid one, with capital frequently locked up for 10 years or more. And this can prove to be a stumbling block for many, despite the undoubted rewards on offer.

“Since the financial crisis and the great disruptions that occurred in asset markets in 2008-2009, private banking clients have been placing a premium on liquidity in the assets they are comfortable holding,” explains Alan Mudie, head of investment strategy at Société Générale Private Banking.

“This is lessening slightly, but the beneficiary of that is more likely to be hedge fund investments than private equity.”

The amounts invested in private equity are beginning to pick up, with most interest coming from the upper end of the spectrum, he adds, but remain way below the levels seen in the middle of the last decade.

“Clients have to be aware that these are leveraged investments into smaller, closely held companies,” explains Mr Mudie. “The level of risk involved in a private equity deal is, and will remain, much higher than that of a traditional equity investment.”

Locking up capital for this length of time can be an issue for some investors, agrees CapGen’s Ms Thorne, but she questions whether it is possible to get 4 per cent real return with managed volatility without using illiquid assets such as private equity.

“In addition, the longer investment horizon of private equity actually suits many private investors, due to their long-term goals and lack of liquidity constraints.”

Indeed, for some wealthy individuals the time frames often are not long enough. “GP/LP structures are still structured around the premise that the fund manager will exit from individual assets after a three to five year holding period, in order to return capital to investors and earn their carried interest. For UHNW clients, their investment horizon often extends far beyond this medium-term time frame.”