Financial advisors should put more wealthy clients in private equity funds, study says

Wealthy clients should invest more in private equity, study says. Good idea?

March 1, 2022 8:16 PM

Some wealth managers, especially independent ones, tend to think of private equity only in the context of Wall Street acquirers of registered investment advisory firms. But private equity is also an asset class for individual investors — and it’s lacking in many affluent clients’ portfolios, according to a new study by Boston Consulting Group and iCapital.

Wall Street’s professional investment machines have been a honey pot for institutional dollars, from endowments to pension funds, for decades. While that money accounts for just over 90% of the dollars in private equity funds, retail investors are increasingly betting on the traditionally exclusive asset class.

BCG and iCapital, a New York-based technology and fund management firm that assists financial advisors, hedge funds and other sophisticated investors with private equity investments, lay out the obstacles, what surmounting them can do for an advisor’s practice and why not getting on board is mistake that can cost clients come retirement.

Here are key takeaways from their March 2022 report, “The Future is Private: Unlocking the Art of Private Equity in Wealth Management.” Financial Planning also looked at recent data and academic research showing that the long-standing “beat the market” reputation of private equity funds may not be all it’s cracked up to be.

The basics

Private equity firms raise money from institutional and affluent investors, as well as pension funds and sovereign wealth funds, then pour the dollars into funds that invest in private companies. The fund typically takes a controlling interest in an operating company or business, known as the portfolio companies, and dives into the management and direction of the company, all with the goal of increasing its value.

The typical goal of a fund is to “exit” those portfolio companies within approximately five to seven years, either by selling them for a profit or taking them to public shareholders through an initial public offering on a stock exchange. Either move can result in big payouts for the fund’s investors. Many funds take a longer-term view and wait 10 years or longer to exit. Investments include real estate, startups, medical practices, retailers, professional sports teams and the music catalogs of Taylor Swift and Bruce Springsteen.

Private equity funds are typically open only to so-called accredited investors. That means individuals with earned income over $200,000 ($300,000 for married couples) in each of the last years, a net worth over $1 million or a Series 7, 65 or 82 license from the SEC to trade public or private securities.

Follow the money

The global private equity market had assets of $5.3 trillion in 2020, according to the most recent data cited by the report, and will double by 2025.
Global individual investors will have $1.2 trillion in private equity funds by 2025, more than twice the $493 billion they had in funds in 2020. More than half, or 52%, of those investors are and will be in the United States and Canada.
Individual investors have only 10% of private equity’s AUM, but growth in theiir share will “significantly” outpace institutional growth.
Among individual investors, the highest growth rates of investor money for funds will come from affluent and retail investors.
Still, most private equity wealth will continue to be held by the ultra and upper high net worth segments.
“We expect individual investors to become an increasingly strategic source of capital for private equity managers: In 2025, individual investors will account for a projected average of 10.6% of all capital raised by private equity funds.”

The price of admission

Individual investors face obstacles to investing in private equity funds. Those include high investment minimums ($25 million, but recently for some funds $25,000, according to Harvard Business School); difficulties in identifying and accessing the best asset managers; and a lack of insightful analysis and education for advisors and individual investors.
Growth in the number of private equity funds and their assets under management is coinciding with a decline in the number of publicly listed companies in Western economies. “These trends should signal a call to action for wealth managers and their private clients, who continue to have very low allocations to private equity.”
“Today, companies stay private longer. With more companies going public much later in their life cycles, a significant portion of value creation takes place outside the public markets. In addition, a wider range of long-term growth investment themes, including promising technologies and health care opportunities, as examples, are available primarily in private equity.”

How advisors can get a piece of the action

“There is a significant opportunity for banks and wealth managers to make it much easier for individual investors to access private equity. In doing so, wealth managers will be meeting an important client need by helping investors more broadly diversify their portfolios and significantly enhance their return potential. Additionally, by expanding their services into private equity, both banks and wealth managers can alleviate much of the margin pressure they are experiencing.”
Wealth managers in partnerships with fintech firms should integrate private equity investments into their services and tools for clients.
Educating clients about the asset class is critical. “Providing a seamless integration of private equity offerings, technology and education will ensure that wealth management organizations can position private equity effectively in their clients’ diversified portfolios.”

Show me the money

Private equity has long been synonymous in the public mind with outsized returns. The BCG/iCapital study said that “Investments in alternatives can add high-return potential to a portfolio. For example, on a net basis (after deducting all fees, including carried interest), private equity has outperformed major indices public market equivalents by 300 basis points (3%) or more over five-to-15, and 20-year periods, according to the Cambridge Associates US Private Equity Index as of July 30, 2021.”

But by other measures, the gap between the funds and broader stock markets has been narrowing, if not disappearing.

Private equity funds gained an average 13.92% over 10 years through Dec. 31, 2020, compared to 13.9% for the S&P 500 Index of leading companies, according to data from the American Investment Council, a trade group and lobby for the industry. The funds’ returns are an average of the gains by five benchmark indices that track private equity returns. Only two of the benchmarks exceeded the S&P 500, while three underperformed it.

A June 2020 scholarly paper, “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory,” by a financial economist at Oxford University’s Said School of Business, found that from 2006 through 2019, private equity’s returns, once investors have paid fees, mirror those of public stock indexes.

Private equity managers typically charge investors what’s known as “two and 20” — a 2% annual management fee based on total assets under management and a 20% performance fee, called carried interest, on the gains if a fund meets its performance hurdle.

This can add up to 7% a year, according to an estimate by Ph.D. economist and chartered financial analyst Brad Case — a multiple many times over that of low-cost index funds that mirror a benchmark.

In June 2020, the SEC issued a stark “risk alert” detailing its concern over a lack of transparency and misrepresentation by some private equity funds.