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The counterintuitive virtues of private equity for rich investors and family offices

Ian Orton, 07/03/2019

Private equity investing can be very rewarding so it is perhaps no surprise that it has started to assume greater prominence for the very rich and their family and/or investment offices.

Nonetheless, a new paper from AQR Capital Management, a firm that focuses on investing in alternatives, called “Demystifying Illiquid Assets: Expected Returns For Private Equity”, suggests that there could be a more counterintuitive reason for the surge of interest in this asset class.

Rather than attempting to capitalise on the superior rewards that private equity investments are often assumed to generate it could be their ability to help smooth portfolio returns that is more desirable.

In other words it is private equity’s apparent ability to make a portfolio less volatile that provides the attraction.

At first sight this appears very odd.

For as David Swenson, the inventor of the endowment model of investment management pointed out in his 2005 book “Unconventional Success”, although private equity can generate the highest returns of any asset class it also generates the widest range of returns.

It is a very risky asset, far riskier than conventional equities.

But this doesn’t necessarily appear to be the case at a portfolio level. For illiquid private assets are not valued on a mark-to-market case, as is the case with conventional equities, for example.

Instead they are valued on a much more infrequent and often subjective basis that has little to do with the day-to-day fluctuations of listed firms. All this makes for artificially smooth returns.

This has a number of advantages.

When equity prices fall, the value of private equity funds often appears to fall less slowly.

A mixed portfolio of public and private equity funds will look less volatile than a portfolio that only invests in listed stocks. The true riskiness of private equity would only become apparent in a prolonged bear market.

The ability to smooth returns can provide rich investors with piece of mind rather than the potential of (eventually) generating good returns.

Furthermore, investors could generate “private-equity” type returns by using more conventional investment strategies.

According to the AQR Capital Management researchers, for example, private equity outperformed the S&P 500 by an average of 2.3 percent a year between 1986 and 2017.

The problem is that private equity investments typically tend to be in small and medium-sized firms rather than the behemoths that populate the S&P 500. Furthermore these tend to have a low purchase price relative to their underlying earnings. In other words they would be considered as “value” stocks.

If an investor had invested in a portfolio of value stocks over the same period the returns would have been significantly better than those generated by private equity or, to be more specific, “buy-outs”.

Other research has shown that investors could also outperform private equity by “leveraging up” a typical equity portfolio to the same level as a typical private equity fund.

Of course some rich investors invest in private equity because it is an asset class with which they are familiar. After all many investors created and ran their own companies and so had first-hand exposure to “direct” or “private” equity.

Irrespective of the motivation private equity is currently very popular with very wealthy investors and their family offices.

According to the 2018 UBS Family Office Report, private equity direct investments accounted for around 14 percent of a typical family office portfolio with private equity funds accounting for another 7.6 percent.

These proportions have risen over the past five years and are expected to rise further over the next year.

Around half of the family offices that participated in the survey that underpinned the UBS Family Office Report said that they intended to increase their exposure to private equity direct investments for example.

Private banks and wealth management firms that cater to the very rich and their family offices are attempting to gear-up to accommodate this increased interest in private equity.

Their efforts can take a number of forms such as offering co-investment opportunities, arranging funding and integrating the activities of their commercial and investment banking arms to facilitate deal flow for their rich private clients.

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