Private equity investing is fashionable. It reflects a belief that with public market valuations so high, investors should look elsewhere. But the bad news is that valuations in private markets also look pretty high.
There are many drawbacks to investing in the sector. For a start, money is not invested when it is committed, so investors must decide what to do with it while waiting for the manager to draw it.
Once invested, the cash is locked in a fund where investors have little to no control or influence – with a potential withdrawal rate of 10 years. And this is before we get to the fees.
Private equity managers eat, perhaps, the largest lunches in the financial world – management fees of 1.5 per cent and performance fees of 20 per cent are normal, with other ongoing charges also payable to those only able to invest between $5m (£3.9m) and $10m.
Some private equity funds quote strong historic performance, but investors should be wary as performance is Darwinian. Only the managers with the best track records will succeed in marketing to new investors, or, to put it another way, it is only managers with long track records that have good track records.
The difference between the gross and net internal rate of return can also be significant. It is not unusual to see an annualised return of 20 per cent pre-fees equate to something below 15 per cent after fees.
Given the popularity of private equity, contrarian investors should probably look elsewhere for opportunities.
The sector is booming. Total undrawn commitments to ‘buy out’ private equity funds is estimated to be more than $600bn, while the total across all types of illiquid funds (including venture, distressed, real estate and credit) is closer to $1.6trn.
So why on earth would anyone want to invest in private equity? The answer is investment performance. We have found that private equity portfolios have generated significantly better net-of-fee returns than quoted equity products at a similar level of risk.
Even with deal prices high compared with history, there is a reasonable chance that private equity funds will continue to perform well. For many investors this is all that counts.
Stanhope Capital invests in a diversified programme of around five or six funds per year in private equity, and perhaps adds allocations to other illiquid assets, such as private credit, real estate or infrastructure. Ideally, this frequency of investing should continue as part of a rolling programme over many years to gain vintage diversification. Depending on the mix of funds, the portfolio will continue to draw capital for the first six to seven years before it starts to become self-funding, with maturing investments covering drawdown demands on newer strategies.
Investing in this manner is not reliant on the investor making major macro timing calls on when to invest, so taking a view on timing becomes almost irrelevant.
Investors should consider allocating 20 per cent of a portfolio to illiquid funds. This allocation should be built up over many years and should be invested in line with the remaining 80 per cent in liquid assets. Given this illiquid portfolio is likely to be drawn down over a period of five to eight years; the cash requirement might only be 4-5 per cent of the total portfolio in any year.