THE ATTRACTION OF PRIVATE EQUITY
Sector resonates with wealthy families, but it’s not for average investor, writes Martin Pelletier.
With stock markets like the S&P 500 setting new all-time highs, interest rates testing new all-time lows and alternative investments such as hedge funds performing badly, investors have begun to look elsewhere for return potential — one such area is private equity.
Here at TriVest we’ve noticed that private equity typically resonates very well especially among those families who generated their wealth by running operating businesses themselves.
We are not alone in this observation as the 2016 Campden Wealth-UBS Global Family Office Report highlights that the average family office has a 22 per cent portfolio allocation to private equity. Approximately two-thirds of this is done through direct and co-investing rather than private equity funds. This makes some sense as it provides more control over the investment process and families can better utilize their previous hands-on business experience.
Private equity funds are not cheap, with fee structures often matching hedge funds with a two per cent management fee and 20 per cent performance fee. That said, hedge funds have been very much challenged to generate enough alpha (outperformance) to justify their high fees while private equity funds have delivered more attractive returns.
For example, the HFRI Fund Weighted Composite Index has delivered a paltry 3.5 per cent annualized return over the past five years to Aug. 31, 2016. While not an exact representation of private equity returns given the overall size and diversity of the sector, a fair proxy would be the S&P Listed Private Equity Index, which is made up of the leading publicly-listed companies that are active in the private equity space. Interestingly, this index has delivered a 9.9 per cent annualized return over the past five years.
That said, before jumping in with both feet, the sector is not for the average investor given the amount of diligence required along with the cost of entry often requiring large minimum investments.
On the other hand, wealthy families only require a fraction of their portfolio to generate more than enough income to cover their spending needs and therefore they can commit to longerterm, less liquid investments that offer a higher return potential such as private equity.
Ideally it makes a lot of sense as an allocation for those with families with portfolios totalling over $10 million.
When it comes to due diligence, the family will have to be very hands-on with a formal plan in place deciding on an allocation and diversification between sectors such as oil and gas, real estate, manufacturing, consumer products etc. It will also help to establish and build out a network of sourcing and screening deal flow to bring to the family’s investment meeting for review.
A formal due diligence checklist should also be firmed up and include but not limited to the ownership level and structure of the management team along with their experience, the amount of control and direct involvement to take, identifying the risk-controls that are in place, what the eventual exit plan or liquidity event will be, and the partners involved from legal to audit.
From experience, for those families new to private equity, a good starting point is to dip one’s toes into various sectors with perhaps a five per cent allocation divided up among smaller initial allocations with the intent to expand it over time as the family becomes more comfortable with their overall process.
Finally, we would also lower one’s overall return expectations and not be allured to the sexiness of the sector. Instead, we think high single digit to low double digit returns would be an ideal target, especially considering the low interest rate environment we’re in.