PRIVATE EQUITY for INDIVIDUAL INVESTORS Historical Impediments and New Opportunities

FEATURE | HISTORICal IMPEDIMENTs and NEW OppORTUNITIES PRIVATE EQUITY FOR INDIVIDUAL INVESTORS Historical Impediments and New Opportunities By Bob Rice he research is clear: Private equity because much of PE’s value derives capital through private placements in typically generates better returns directly from its illiquid nature. For exam- which investors commit to a total funding T than the public markets. The advan- ple, as a private form of equity, there is no level, but only periodically remit cash, in tage, at the index or median level, typically public market for buyer and seller to come chunks, on demand, and over time, when runs to an average of 300–400 basis points together and agree on a price, which is an capital is called by the general partner. per year.1 To address their funding gaps essential characteristic of tradable liquid and operational budgets, institutional securities. There is no fair disclosure This system reflects the fact that private investors such as endowments and defined requirement in private markets, and the equity fund managers themselves must benefit plans have made private market resulting information asymmetry provides deploy capital slowly. Once they have capi- allocations a staple of their portfolios. But an investment advantage that allows for tal commitments in hand, they must iden- individuals and defined contribution plans investors with potentially superior out- tify and perform diligence on private remain relatively underexposed, if not alto- comes down the road. targets, select them, and then negotiate gether unallocated. transactions on favorable terms before cash In addition, the purchaser of a private com- is expended. Only then will capital be The main reason is clear enough: The illi- pany may have near complete control over called, and only the amount that can be quidity that is a hallmark of these strategies is the entity. That control includes changes in readily spent. Note that if the manager were not a hurdle for institutional investors with management, pursuit of long-term opera- to raise all the investment capital up front long time horizons, but it’s a very big obstacle tional improvements, splitting off unpro- that it wishes to deploy over several years, for most individual investors. Other factors ductive components, expanding research investors’ returns would suffer as the man- contribute, too: high investment minimums, and development, accelerating product ager sits on big piles of uninvested cash. steep net-worth qualifications for investor development, and improving distribution, (Conversely, a manager who doesn’t have participation, complex tax treatment, and all on its own time (and dime). Such con- ready access to pre-committed funds can’t even the inability to source (and access) trol can strongly incentivize executives to effectively negotiate and pursue deals). So quality opportunities, in part due to limita- achieve certain goals, because there is no capital calls are the signature modus ope- tions on advertising private placements. But need to maintain current dividends, answer randi of traditional private equity funds. recently new product types, emerging plat- to analysts on a quarterly basis, or wage forms, and trading technologies, as well as proxy battles. A typical PE fund’s entire investment pro- key legal and regulatory changes, have made cess occurs over four or five years. After private equity (PE) a more realistic opportu- In short, many of the return characteristics each investment it takes substantial time to nity for individual investors. of PE are directly linked to its private (and improve the underlying company through therefore usually illiquid) nature. To begin the management changes and resource All the new product options come with to answer how to reconcile the ideas of pri- injections mentioned above; and yet more tradeoffs. This article provides a quick map vate equity and liquidity, let’s consider how time to negotiate and execute the exit, of the ways individuals can invest in PE, classic PE funds get and deploy capital. either through a sale to a strategic buyer or along with discussion of the main benefits an initial public offering. So each invest- and drawbacks of each approach. The Mechanics of Illiquidity: ment position, once taken, may require The J-Curve and Cash Drag another three to six years to ripen. Private Equity—Its Benefits Traditional private equity funds are private and Drawbacks partnerships in which the fund manager is As a result, an investor’s net flow of funds is Let’s start with illiquidity. The phrase the general partner and the investors are usually negative for a period of years, then “liquid private equity” is an oxymoron, limited partners. The partnerships raise flattens as the last commitments are paid and JULY / AUGUST 2017 17 © 2017 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | HISTORICal IMPEDIMENTs and NEW OppORTUNITIES Because the era of public companies that Figure 1: The J-Curve are PE sponsors is new, data on how well they do for investors compared with traditional PE funds is too scarce to be reliable; but it’s hard to believe that the performance won’t be quite different. (After all, oil company stocks historically have had only a modest correlation to oil prices.) Cash Flows Another access point via the public markets could be a set of microcap companies, or Internal Rate of Return even an index that purports to identify the market areas in which PE firms are active buyers. The latter is reminiscent of retail Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 funds that attempt to track the investment Cashflows Internal Rate of Return proclivities of hedge funds by following the Source: Wilshire Associates investment behavior indicated in SEC Form 13F filings.3 But neither approach the first deals start to be liquidated, and then J-curves and complete illiquidity of the captures the core argument of PE, which accelerates towards the end of the cycle. A investment. includes the information advantage; the graph of those flows—and associated internal ability to buy firms at large discounts; the rates of returns (IRRs)—often looks like a But the JOBS Act made changes that ability to apply direct, operational interven- tilted and gently sloping “J” (see figure 1). should open up investment to a far greater tion to improve the fortunes of specific, potential audience. In addition, a new owned companies; and the ability to deter- As cumbersome as this process is, it is ruling from the U.S. Securities and mine the most beneficial time and also the most economically efficient way Exchange Commission (SEC) permits a approach to liquidating the investment for general partners to gather and deploy new and readily tradable type of regulated with a sale to a strategic buyer or a move the cash. As a result, most newer products investment company (RIC) for illiquid back to the public markets. that offer alternatives to the process suffer securities. But before we review these crit- some form of cash drag that reduces ical developments, let’s look at how else Business development companies (BDCs) returns. individual investors might seek out private are another route. Most investors think of equity-type returns. BDCs as strictly income vehicles that pass Lowering the Velvet Rope: through interest on loans made to small Investor Qualification Exploring Potential Liquid private companies. However, BDCs were and Fund Access Options: A Survey of designed as public vehicles that could fun- This traditional fundraising process has Tradable PE Proxies nel growth equity capital into smaller com- profound implications for which kinds of A handful of PE proxies are available in the panies. Alas, that purpose has largely been investors the general partner will solicit and market, some of which offer far greater lost in the race for yield, although a few accept as limited partners (because it must liquidity than traditional PE. The most BDCs operate as equity funding vehicles be confident that capital calls will be met). obvious proxy would be for investors to buy and can provide decent exposure to pre- And before the JOBS Act, which took full the public securities of major private equity public growth companies. effect in 2016, two other factors also were at firms. This easy path provides complete work.2 First, the total number of investors liquidity and some indirect exposure to the Finally, for those who can buy and hold in a partnership was restricted to just 500 success of PE funds. But it doesn’t provide a stocks listed in Europe, some funds have limited partners (LP). So to raise a large simple pass-through in terms of the risk listed shares there instead of going the LP fund, a general partner (GP) had to find and return profile of the underlying private route. But cash drag raises its head here. a relatively small number of LPs who, funds. The investor is buying into the earn- Because these funds must launch by raising together, could invest the total amount it ings stream and distributions of a public most or all the funds they hope to deploy, was targeting. Second, the private place- company, an investment that correlates investor returns are bruised by large sums ment process limited the availability of with public market behavior. Also, in most of capital sitting idle for long periods. In information about PE funds to a narrow set cases the beta of publicly listed private addition, the trade by appointment nature of institutional investors. As a result, almost equity companies tends to be high, well of most of these listings can result in poor no individual investors could join the PE above 1, so they tend to trade with volatility pricing to a seller, making the liquidity club, even if they could stomach long greater than that of the market.

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