The shine has come off private markets of late. A slow-motion run on global private funds aimed at retail investors is bringing new headlines each week about savers being locked out of their investments.
Closer to home, small-scale investors in the pioneering Toronto-based Kensington Private Equity Fund have voted to dam themselves into the fund to prevent a rising stream of redemptions from turning into a value-destroying flood. Meanwhile, large pension funds, including the Ontario Teachers’ Pension Plan and Ontario Municipal Employees Retirement System, have written down the value of their private equity (PE) books as the industry struggles to emerge from its slump.
Against this backdrop, regulatory initiatives aimed at expanding access to private markets to everyday investors, such as the Ontario Securities Commission’s Long-Term Asset Fund project, look a little out of touch. Still, we should not dismiss these initiatives out of hand. If private equity funds have historically delivered superior returns, is it right for regulators to restrict access to them just because they’re complicated?
But more to my point: the inherent structure of private markets might mean that such ethics are moot, because money managers can’t offer private markets products that meet savers’ needs. Just as a reliable and affordable truck is a better vehicle for your average plumber than a two-seater supercar, a transparent, low-fee portfolio is a better fit for their RRSP than a high-octane private equity fund.
Proponents of expanding access to private equity argue that it offers an important source of diversification that can help investors offset risks while keeping returns high.
We can dismiss this argument out of hand. Research consistently shows that private equity returns move more than one-for-one with public equity returns. That means that each unit of public equity you reallocate to private alternatives will increase your risk exposure to the same underlying factors. Adding PE to a portfolio does not diversify risk; it amplifies it.
Plus, if you’re trying to limit the “concentration risk” that is pooling up in public markets, look elsewhere: According to financial data platform PitchBook, 18 per cent of PE is allocated to software firms alone. PE is even more heavily tilted to technology than the S&P 500.
So, the debate really comes down to who gets access to the “excess return” that private markets have historically generated over their traditional public counterparts. Academics are divided on exactly how big this excess is, but it’s widely accepted that it exists. To see why this excess might not apply to retail investors, let’s take a look at the ways that PE firms generate it. I call them the three “Ls.”
First is liquidity, or rather, the lack thereof. By making long-term bets, private equity funds avoid the ups and downs of the market, and, all being well, can time their sales to maximize returns. To make this work, investors are not permitted to withdraw their commitments. If this were all private funds did, long-term, inaccessible retirement saving vehicles like RRSPs would appear to be a natural fit for them.
But it’s not all they do. PE funds also juice up returns with a second “L”: leverage. By borrowing against the acquired company’s balance sheet, PE dealmakers improve their return on equity. The trade-off is a higher risk profile. Consulting firm McKinsey & Co. attributes nearly a third of investment returns on private equity buyouts to leverage. While typical of private equity, using leverage is not a unique strategy. Other asset managers, which retail investors already have access to, use derivatives to do the same thing.
The third “L” is “legwork,” the hard yards that keep overcaffeinated PE associates from their beds and families. They research investment theses. They scan, filter, and monitor thousands of private companies. They maintain relationships with potential sellers of priority targets. They conduct due diligence processes. They put together complex deals. They manage stakeholders. They develop turnaround strategies. They implement them. They hire and fire executive teams. They make “add-on” acquisitions. They sit on portfolio company boards. They conduct oversight and liaise with regulators. And when the time comes, they do it all in reverse when they list or sell their portfolio companies.
This is challenging and expensive work, well-compensated by private funds’ famously high fee structures. It’s also where private equity makes its case for providing genuine economic value. For larger listed companies, legwork is incumbent on the companies themselves, who must adhere to strict reporting standards and fulfill fiduciary duties toward their shareholders. Successfully connecting savings to the capital needs of smaller unlisted companies requires special expertise, which PE funds provide.
The point here is that “legwork” is a structural feature of private equity. Without it, there is no hope of generating sustained excess returns over public markets. It is also unavoidably expensive. In fact, investors should not want it to be cheap: when corners are cut on due diligence, monitoring, reporting, risk management, and compliance, retail investors tend to get hurt.
“Legwork” does not scale inversely to the number of investors in a fund – quite the opposite. That makes it very different from low-cost ETFs or even actively managed mutual funds. And there’s the rub: broadening the investor base will not mechanically lower fees or costs.
PE is a luxury good: high-quality, expensive to produce, and best appreciated by discerning investors.
Back to the regulators. Their job is not necessarily to limit access to luxury goods. It’s simply to prevent cheap and harmful knockoffs from flooding the market. From there, the logic of the market will decide whether there is a case for retail-focused PE.
Dylan Smith is the founder of arcMacro, a research and advisory firm specializing in macroeconomic analysis for institutional and private market investors.