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

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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. argument a bit thin.4

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True Illiquid PE for structures, remembering that the GP of the can provide far greater diversification across Individual Investors feeder fund is not usually the same brand- vintage years, styles, and geographies— Apart from these PE proxies, there are other name firm that’s running the fund into something that is extremely difficult to ways for higher-net-worth investors to which the feeder invests. This is not a seri- achieve with any single investment in PE. approach true private equity. The different ous risk for feeders sponsored by major In addition, FOFs often offer smaller mini- structures have different implications for financial institutions, but as independent mum investments than the PE funds into liquidity, time horizons, fees, performance, feeder fund platforms proliferate, it’s a which they invest. However, they are typi- investment size, diversification, practical point to bear in mind. Investors in feeders cally open only to QPs, and their illiquidity diligence requirements, tax reporting, and must be comfortable that the organization is often greater than single PE funds, even counterparty risk. Moreover, legal serving as the GP of the feeder will dis- because the underlying funds all have dif- structures and investment strategies can charge its duties properly and be around for ferent investment periods and separate overlap in different ways, which can make the duration of the fund. market cycles to navigate. commonly used labels confusing. Feeder funds historically have been as illiq- Also of note, FOFs charge their own fees on Feeder Funds uid as the underlying private equity fund top of those charged by the underlying PE Feeder funds are limited partnerships that into which they invest, but changes are funds. Feeders usually charge only an typically use all their funds to invest in one afoot. For example, the Nasdaq Private annual administration fee, but FOFs usually specific brand-name private equity fund. Market recently announced its designation charge both an annual fee and an incentive Investors become LPs in the feeder fund; as a qualified matching service for such performance fee, as much as 10 percent of the feeder fund is an LP of a traditional PE funds. This would permit it to operate peri- the investment returns achieved over a fund. As a result, investors in feeders can odic auctions for feeder fund interests, given hurdle rate. This fee layering has con- access well-known private equity funds although total share transfers within a tributed to a decline in FOF popularity with much smaller minimum commit- given year would be limited to 10 percent among institutional investors (which can ments than otherwise required (say, by Internal Revenue Service rules (exceed- usually diversify on their own), but the $250,000 or less, rather than $5 million or ing that limit could cause the fund to be vehicles remain a reasonable way for indi- more—a typical account minimum for considered a publicly traded partnership viduals to approach private equity. most investors going direct into a private fund). Nevertheless, most feeder funds are still offered almost exclusively to qualified purchasers (QPs or individuals with at least This fee layering has contributed to a decline $5 million minimum of net worth). “in FOF popularity among institutional investors Most feeder funds are sponsored by the (which can usually diversify on their own), but the home office of traditional wealth manage- vehicles remain a reasonable way for individuals ment wirehouses or private banks, but a to approach private equity. number of independent firms also provide this service. In addition, a small number of ” PE firms create and operate feeders into their own traditional funds. and taxable as a corporation). When this Registered Limited Partnerships service becomes available, one can imagine A promising recent development for indi- Feeder funds do offer smaller minimums, that some new feeders will be designed to vidual investors seeking exposure to private but they also have greater expenses that operate on this basis, and investors in older equity is the arrival of traditional private diminish returns. The feeder fund itself feeders may have new opportunities for equity LPs that have been registered under must issue capital calls to its investors when interim liquidity in their investments, the Securities Act of 1933. This permits it receives a capital call from the underlying depending on whether the GP of the feeder much broader marketing and distribution PE fund, and these capital calls incur all decides to participate. and allows an unlimited number of accred- sorts of accounting, tax reporting, and ited investors into the fund—enabling it to record keeping requirements. Typically, the Fund of Funds dramatically reduce minimum investment general partner of the feeder fund will The phrase "fund of funds" (FOF) refers to size without using a feeder. Moreover, the charge 50–100 basis points to cover these a general partner that invests in a range latest product to market in this format fea- activities and make its own profit. of underlying PE funds (as opposed to tures lower fees than traditional private feeders, which usually invest in just one). equity funds and attempts to shorten the Investors also should be aware of the poten- For smaller investors, this approach can be classic J-curve through its mix of invest- tial for counterparty risk in feeder fund extremely attractive, because these vehicles ments. However, investors still must

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Table 1: Comparing PE Investment Structures (Typical Characteristics; Exceptions and Variations Exist in Each Category) Single Interval Interval Nasdaq Fund Single Private Fund— Fund— 33 Act Equity Private Classic Fund Funds of No Tax RIC Tax Registered LP Crowd Market LP Feeder Funds Election Election Fund funding RIC Capital calls yes yes yes no no yes no no Minimums large small large small small small small small Tax reporting K-1 K-1 K-1 1099 1099 K-1 K-1 1099 IRA eligible? no no no no yes no ? yes Liquidity none none none quarterly quarterly none none monthly Fees (not includ- 200 bps+ added approx. 200 bps and two two two two ing. Distribution 20% over admin 80 bps+ 20% over levels levels levels levels costs) hurdle costs 1.5% over hurdle hurdle Cash drag? yes yes yes yes yes no no no Typical investors QPs QPs QPs AIs AIs QCs AIs AIs

commit to capital calls, deal with tax equity (see sidebar). These are RICs that Nasdaq Private Market RICs reporting via K-1s, and understand that the themselves become LPs in several classic A recent and potentially important devel- investment is fundamentally illiquid. private equity funds—thus, they are funds opment has been the SEC’s approval of of funds, except investors participate through Nasdaq’s request to operate an auction Private Equity Crowdfunding a RIC. market for a new type of private RIC. The Spawned by the JOBS Act, equity crowd- new vehicle is designed to hold illiquid funding sites offer access to private invest- A core benefit of these funds is that they are securities, be continuously offered, and ment deals to accredited (and in some cases continuously offered, meaning that they trade (albeit monthly, not daily). This non-accredited) investors. Typically issue new shares whenever more capital is marks the first time this trio of features focused on earlier stage venture deals, these needed or to accommodate new investors. could be combined. sites provide for simpler access. But these As a result, investors in these funds need platforms are new, and the track record of not commit to future funding and do not Only accredited investors may purchase their underlying investments is short. Also, face capital calls. these securities, and only financial profes- venture can be a particularly risky prospect sionals and institutions will have direct (recall that only the top handful of venture But probably the most touted benefit of access to the Nasdaq marketplace. Auctions capital funds capture nearly all the indus- these structures is their liquidity; they typi- will be facilitated by market makers, and all try’s profits), especially for platforms that cally offer to redeem up to a stated percent- buy and sell interest will be aggregated to do not co-invest alongside more proven age of total capital on a quarterly basis. Of create a single clearing price for all transac- venture firms or provide rigorous due dili- late, this system has worked fairly well to tions (a handy protection for individual gence in their sourcing and management provide as much liquidity as holders have sellers). of their deals. And equity-crowdfunding desired, but there have been noteworthy investors are still subject to the typical illi- failures in the past during market disloca- Overall, the structure can be loosely quidity of PE, because venture deals are tions. This is not terribly surprising, thought of as a slow-motion exchange- notoriously long-lived. because a fund can only hold so much cash, traded fund (ETF) for PE because, although and its ability to quickly dispose of its core primary liquidity is through trading instead True PE for the Affluent Masses: investments is very limited. of redemptions, it also has an embedded Solving for Liquidity and Access arbitrage mechanism analogous to the one The high bar of investor qualification com- This mechanism also introduces cash drag. that keeps ETF prices in line with the net bined with long-term illiquidity is a contin- The cash that funds keep on hand to address asset value of its basket of securities. uous theme in any discussion of private redemption requests creates a direct hit to equity. A few notable product structures their internal rate of return (and results in As a fund of funds, these structures could attempt to solve for both—within limits. relatively high management fees being paid involve greater total investment expenses on inactive dollars). Performance also can than direct investment in a classic PE lim- Interval and Interval-Like Funds be adversely impacted by the cost of compli- ited partnership. On the other hand, they Interval and interval-like funds are the pri- ance and operations associated with quar- should offer a path to private equity invest- mary way that accredited investors (those terly tenders. But with those caveats in ment that does not require capital calls, is with a minimum net worth of $1 million, as mind, these structures arguably may offer liquid via an active marketplace, is diversi- opposed to QPs) gain access to true private today’s best marriage of PE and liquidity. fied, reports via 1099s, and limits cash drag

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because it will not need to hold cash to regulations. Title III, known as the Crowdfund Act, such funds’ ability to own most types of PE assets creates a way for companies to use Internet-based (aside from private debt securities). The SEC takes the meet quarterly redemptions. crowdfunding to issue securities, and to raise capital. view that private equity investments are inappropriate 3. SEC Form 13F is a quarterly filing required of institu- for retail investors. tional investment managers with more than $100 million Table 1 shows a comparison of the various in qualifying assets. 4. Publicly traded closed-end funds would seem like the PE investment structures discussed here. To take the CE uiz online, visit www.IMCA.org/IWMuiz logical place for traded PE, but the SEC has limited Summary Given today’s extremely modest expected THE INS AND OUTS OF INTERVAL FUNDS returns for stocks and bonds, as well as the basic need for broader diversification, private equity has a powerful natural appeal Interval funds may provide the most interesting way to translate the benefits of illiquid private markets to for affluent individual investors. A steady individual investors, but there are some key differences to appreciate among the products in the market. march of new laws and regulations, product One is particularly confusing: These funds are registered funds, but they might or might not be RICs. types, and distribution platforms has finally You read that right. They are all registered investment companies under the Investment Company Act of made it a realistic option for them. 1940—but they might or might not elect to be treated as regulated investment companies for tax purposes. The tax election version is preferable for most investors, because regulated investment companies report But, of course, advisors must choose via 1099s, not K-1s. Importantly, they also automatically shield investors from unrelated business income among them. Despite this article’s focus on (UBI) issues, making investment through individual retirement accounts plausible. structure, the most important factor is the manager(s) of the vehicles: Performance Another difference with important implications for investors is whether the RIC is a single-manager fund dispersion is so great (and its persistence (that is, all the funds into which the RIC invests are operated by a single big-name PE manager), or a is so significant) among PE funds that multi-manager fund. Single-manager funds carry the cachet of a famous brand, but note that the Invest- only managers with solid track records ment Company Act does not permit the RIC to invest in affiliated funds—so these products are sponsored should be considered seriously. The next and advised by a group independent of the manager to which it allocates. most-important factor is liquidity. If clients A subtle but crucial issue to consider in these cases, therefore, is whether the independent RIC really has cannot certainly and comfortably hold a all the access it desires to the best of the brand-name manager’s funds and investment options. In a world position and meet the required capital where the best PE funds are constantly oversubscribed by institutional investors, some famous PE manag- calls for the lengthy investment horizons ers may not be terribly motivated to provide capacity within the best opportunities for semi-retail investors required, then advisors should consider when it would mean cutting back (and maybe alienating) institutional investors with which the manager has interval funds or the new Nasdaq Private long-term relationships. This dynamic can hinder allocations of cash on hand at the RIC into active use and Market RIC for clients. If illiquidity is not accentuate cash drag. an issue, but large investment minimums are, then a registered LP interest, or feeder By contrast, fund sponsors operating multi-manager RICs have better opportunities to diversify and, fund, may be suitable. If neither illiquidity naturally, more opportunities to rapidly deploy the funds they raise. nor large minimums are issues, then the traditional LP structure may be the best choice.

Acknowledgments The author gratefully acknowledges the significant contributions of Avi Sharon, PhD, in the preparation of this article. Expert thinking on relevant topics that impact Bob Rice is managing partner at Tangent Expert thinking on relevant topics that impact your business. IMCA updates on important Capital and Rice Partners and author of The your business. IMCA updates on important Alternative Answer and Three Moves Ahead. happenings at your professional association. Contact him at [email protected]. happenings at your professional association.

Endnotes Read the latest posts, share 1. See Robert S. Harris, Tim Jenkinson, and Steven N. Read the latest posts, share Kaplan, “Private Equity Performance: What Do We content with colleagues and Know?” Journal of Finance 6, no. 5 (October 2014): content with colleagues and IMCA 1,851–1,882. 2. The Jumpstart Our Business Startups Act (JOBS Act) peers, and let us know whatblog seeks to encourage funding of small businesses in peers, and let us know what the United States by easing a number of securities you think.you think.

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