Private Access: Should We Beware?

This essay was originally published by CFA Institute on the Enterprising Investor.

Quotes like this are circulating:

“Retail investors [don’t have] access to [private investments and] we want to make sure retail isn’t left behind.”

And, leaders in government seem to think that “retail investors [are] missing out.”

Firms like Vanguard are also reportedly thinking about getting into the business, which might lower fees, that some say can average 6% per year

I’m all for access, but in this case I wonder:

What Type of Access Will People Have?

I started investing in private equity on behalf of clients in the early 2000s and still invest in the space in large absolute dollar amounts. I do think “some private investment opportunities can provide investors with solid returns.”

When considering giving “access” to larger groups of retail investors, however, we should keep in mind what I’ve had access to:

Comparisons That Are “Not Recommended”

Below, I’ve reproduced a private equity return chart that is published every quarter. It is normally the first headline chart in the presentation book that highlights so-called private equity “net to limited partner” returns. These returns appear in many private equity marketing presentations, are quoted in various publications, and are used to create standard deviation and correlation charts to make a case for private equity.

As one of those quoted above said, it is true that “over some periods of time [these] investment opportunities [may] perform better.”

But here’s a question that probably should be asked before access to these return comparisons are made available to larger audiences:

Why are these net to limited partner returns compared with public indexes when, in small print, there’s the following disclosure?

“Due to the fundamental differences between [how private equity and public market returns are calculated], direct comparison . . . is not recommended.”

In fairness, the disclosure goes on to say that “for a more accurate means of comparing private investment performance relative to public alternatives,” investors should look to adjusted public market returns on the next page.

This is useful material, as are the other metrics presented in an analysis section at the back of the book.

But did any limited partner or investor receive what the firm states on this subsequent page are “actual private investment return(s)”?

As I’ve written before, some firms disclose, in fine print, what these “actual private investment return(s)” might be:

Returns “No Client Received”

Some firms don’t.

Again, why not?

In fine print, you also find this about the calculation of the net to limited partner returns:

“The timing and magnitude of fund cash flows are integral to the . . . performance calculation.”

Do all potential investors understand what this means and how it can affect returns?

And what about other potential issues to consider, like the “spreading rapidly, like a zombie outbreak” use of “fund level engineering” that can “optically boost” the limited partner returns that academics have reported might already be inflated in the first place?

As one leading private equity professional recently said, a form of this return engineering “could potentially lift [the returns I’ve been mentioning] by 3% or more” — again — beyond returns that might already be high compared with the actual cash-on-cash returns that investors may have received.

On the page I referenced that might portray a more “accurate” comparison of private and public equity returns, the firm does make adjustments to the public market returns in an attempt to create a better apples-to-apples comparison. But they still use the prone-to-be-engineered in more ways than one net to limited partner returns that some say “no client received.”

Again, why?

Access can be great, and to be clear, as far as I know, nothing is technically wrong or non-compliant in the way the private equity returns I’ve mentioned can be presented to “accredited” or “sophisticated” investors.

As Howard Marks, CFA, noted some time ago, there is no easy way to evaluate private investment (PE, venture capital, etc.) returns and so:

“Complex, Multi-Dimensional Analysis Is Required.”

Marks and other “accredited” and “sophisticated” investors have the background and the resources to conduct such analyses.

Are the retail investors, who may soon have expanded PE access, similarly equipped?

Before making more of the “best stuff” available, should a few of my “why” questions be answered in an easy-to-understand manner?

As I wrote in my first piece for Enterprising Investor, “I believe it [would] be a positive for investors and for Wall Street, which many studies show has a big image and confidence problem, especially among younger generations who are the industry’s future.”

Until then, maybe access should be accompanied by clear warning labels stating something like the following:

“Unless you are well versed in the myriad ways private investment returns, standard deviation, and correlation metrics are calculated and fully prepared to ask a lot of technical and often hard ‘why’ questions, buyer beware:

“You may be purchasing so-called net returns that, ‘over some periods of time,’ ‘no client received.’”

Further Reading

• “Internal Rate of Return: A Cautionary Tale,” McKinsey & Company
• “The Truth about Private Equity Performance,” Harvard Business Review
• “Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting,” Harvard Business School
• “Chapter 11,” Private Equity Laid Bare, Ludovic Phalippou
• “Are Lower Private Equity Returns the New Normal?” Center for Economic Policy Research (CEPR)
• “Hedge Funds and PE Are Weak Performers after Creaming Off Large Fees,” Financial Times
• “Private Equity’s Trick to Make Returns Look Bigger,” Wall Street Journal
• “Preqin Special Report: Subscription Credit Lines,” Preqin