By Robert McGrath
At Overbay Capital Partners, we believe that investing in Private Equity can offer significant outperformance over competing asset classes. Yet the eye-popping outperformance of the last few decades over equities and fixed income masks many significant risks for investors, and a less-than-optimal investor experience. What risks do investors face; you ask? Or why isn’t the investor experience generally a positive one?
To answer these questions, consider the following parable…
Let’s imagine (or maybe you don’t have to imagine) that you have built a great investment portfolio, accumulating seven or even eight figures of investable assets. Through painstakingly putting money away, or building and selling a business, or investing smartly in real estate, or careful management of your family’s estate, you’ve built up these assets and secured your and your family’s financial future. And though you haven’t invested in private equity thus far, you know that the asset class has significantly outperformed equities over the last decade.
Maybe it’s time, you think, to take the plunge into private equity. You meet with your investment advisor and ask her if she thinks you should. “Maybe” she says, “but before we put your money into direct investments (single companies) or in PE or VC funds (by contributing to a pool of capital that they are raising) let me ask you a few questions.”
“Question one: are you a celebrity like Ashton Kutcher2? Or perhaps a captain of industry?”
You pause for a moment. You did act in your high school play. Your kids tell you that you’re “above-average funny.” But the parallels to Ashton stop there. And as to being a captain of industry, well, you’ve been successful, but the cover of Fortune magazine is not something you aspire to. But why should this matter? Your advisor explains:
“When it comes to direct investing in private businesses, the best deals go to celebrities like Ashton, Bono or to titans of industry, who amplify the story around these businesses and increase their likelihood of success. That’s why investors like Kutcher, with his Sound Ventures firm, or Bono, with Elevation Partners, get the pick of the litter, along with investors like Jeff Bezos with his Bezos Expedition firm.”
“If you aren’t in this stratosphere and you’re getting a direct investment opportunity – it’s probably not in that top echelon of quality.”
Disappointed that direct investing won’t give you the cream of the crop, you ask about investing in a fund – could you invest in a fund managed by a prestigious firm like Kleiner Perkins or Sequoia? After all these sorts of firms have backed so many world changing companies like Amazon, Apple and Google. Your advisor continues with,
“Question two: are you running a multi-billion dollar endowment or a mission-driven institution?”
You don’t have to pause very long. You built a great company, are an expert in your profession, and give back to your community. But you aren’t running an organization like the Harvard endowment or the World Wildlife Fund. But why should that matter? Won’t Kleiner Perkins or Sequoia take your cheque? Your advisor sighs and explains again,
“Well, the best private equity and venture capital funds are oversubscribed, and their managers only want to admit the most prestigious investors to their funds. Having these organizations as backers serves as a beacon that not only draws investment dollars but also increases the profile of the businesses and their likelihood of success. And if you can choose your investors, why not select the ones doing the most good?”
As this sinks in, you feel like you are back at high school again, with the cool kids table already filled up. But you know there are smaller firms, with less prestigious names but promises of outperformance. Surely they could be good choices for you?
“While top firms and funds are virtually closed to ‘ordinary’ investors, it’s true that there remain others that you could invest in. And though they may not reach the lofty performance heights of the stars, they can often outperform equity benchmarks over time.” Your excitement builds again, until your advisor continues, “But before you invest with these firms, I have just two more questions for you…”
Question three: “Are you prepared to wait five years to have your capital called…and ten to fifteen years to get your capital out?”
Your experience in investing over the last three decades has been simple. You have investable cash. You identify the best asset – a stock, a mutual fund, a piece of real estate, a bond – and you purchase it, putting your capital to work. And when you need liquidity, you sell that investment usually with little lag time. Your advisor explains that investing with these PE funds will be a very different experience.
“When you sign up to be part of a private equity fund, you are making a commitment to a manager, rather than making an actual investment. Once the fund has raised capital (or commitments) from investors, the manager will look for companies to invest in. It can take years for the portfolio to be assembled, and during those years you need to keep your cash ready as the capital calls come in. This can take two, three or even five years. Then you wait as the manager works to improve these businesses and for the exits to begin. This can take another five to ten years. You will be waiting years for your capital to be put to work, and then you’re waiting years for it to be returned to you. You’ll need to think carefully about your willingness to park and wait as capital is deployed, as well as your willingness to wait for it to be returned to you.”
As you’re wrapping your head around this, she hits you with one more:
Question four: “Are you prepared to make multiple PE investments across strategies and over several years to avoid the concentration risk?”
“While average returns for private equity have been strong, individual fund returns are all over the map. It is a very risky asset class. Also, every year is different, and some years are better than others to invest in PE or VC. Given that you can’t predict the future, you need to diversify your investments across strategies and multiple vintage years. This is exactly what major institutions do. If you can’t make at least three fund commitments per year for several years you run a very high risk of underperformance and even loss of capital.”
Writing a big cheque that you won’t get back for 10 to 15 years is one thing. Writing big cheques every year is another.
Summary
Seeing your crestfallen expression, your advisor wraps up,
"Hey, you may not be a TV star, but you’ve been very successful. You made sound choices in your career and your life, prudently accumulated wealth, and now have a thriving investment portfolio. Traditional private equity may sound alluring, but I hope you can see that it comes with some significant risks and an investor experience that is not particularly good.”
“But before you give up on PE… there is this firm called Overbay we should talk about.”
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1 Insead: Re-Thinking Private Equity Risk and Reward for LP Allocations, 2020
2 You may be surprised - Ashton Kutcher is well known in the venture capital world for being a very shrewd and successful investor. He has backed companies such as Airbnb, Spotify and Uber. Who needs "That '70s Show" residuals with those sorts of homeruns?