Real talk about private equity: Truth, trends, and tradeoffs

 

Christine Kashkari: Welcome to Better Vantage by Vanguard, a podcast series hosted by custom content from WSJ and Vanguard. In this series, we'll cover the issues that are top of mind for financial advisors and investors. And with me today is our co-host, Joe Davis, global chief economist at Vanguard. Joe, good to be with you again. 

Joe Davis: Always a pleasure, Christine.

Christine: And for today, our special guest for this episode is Scott Voss, managing director and senior market strategist at private equity firm HarbourVest. Scott, welcome. 

Scott Voss: Thank you, I feel privileged to join this party. 

Joe: We've had the opportunity interacting a few times—Scott wouldn't mention because he's too humble, but he's also in the past chaired the investment committee, HarbourVest.  I'm excited — it’s not just you're in the space of private equity, but also let's get to the education point, Scott. There's certainly some benefits and interesting dynamics in private markets. There's also potentially some hype or some are critical there, so this is a service for investors. I'm really interested, given all the hats you've worn and your perspective on: How should I think about this? And let's cut through the clutter here. 

Christine: Joe, you lead Vanguard's Capitalize Investment Strategy Group, you chair the strategic asset allocation committee that oversees the design of multi-asset class portfolios — it's across the firm …

Joe: So similar sky, multi-asset allocation…

Christine: And you've authored a peer-reviewed research on private equity, as well as served on investment committees with direct oversight of PE allocations. 

Joe: Hopefully, I can channel our team's research, where appropriate, and how we have to think through these issues for investors with public and private market exposure. 

Christine: So Scott, HarbourVest has a relationship with Vanguard in the private equity space, and we'll get into that a little bit later. Can you give us a high-level overview of what private equity is for people that may still be confused? 

Scott: Sure, absolutely. Fortunately, it is what it sounds like — it's private equity. It's investing in companies that are privately held that can't be bought and sold on an exchange. And typically, those transactions are a 1-to-1 negotiation between the buyer and the seller. 

I'd also say it's a value-added capital. So instead of just taking an economic interest in the company, the investor is also playing a role in the day-to-day operations of the company. They might help a company set up corporate governance, where it hasn't existed up until now. They might help them think about strategic directions they want to take the business. They can help them with their capital markets needs. They can help them fill out their executive team if they need to.  

Christine: There's a lot of excitement now, and Joe's alluded to that. Do you think part of that is because quantitatively there are fewer publicly traded companies? 

Scott: If you're a diversified investor in the U.S. markets* or the European markets,** by number, less than 5% of the companies that make up those markets are actually publicly traded. So if you want to access the entire market opportunity, the other 95%, you need some type of private market allocation. It shouldn't be 95% of your allocation, but there's a reason why that should be in a portfolio. 

Christine: So Joe, we are seeing a lot of traditional asset managers getting into the private equity space, including Vanguard. 

Joe: Oh, here we go. Is this the hot seat? 

Christine:
Yes, it is. And a lot of people are wondering: What is a pioneer of simple, low-cost investing doing in a space that's known for complexity and high fees? 

Joe: I firmly believe it's fully aligned with the mission of Vanguard — and I would hope other asset managers — of lowering the relative cost of investing and to increase the investment opportunity set for investors to be ultimately successful. And in many ways, I view private markets — the potential for private markets — as an extension of Vanguard's long, and I would argue, successful legacy in low-cost active management. 

There's two things that, when combined, can be powerful and that's low cost, or lower cost relative to whatever the average cost of the investment is, and the skill, if you can identify skilled managers. It's not because public markets have fewer securities publicly traded today. It's not because you read private companies are staying invested longer. Those are second-order issues in my mind to: Can we expand the opportunity set in a lower cost way, with skilled managers have the ability to identify those future unicorns or those lottery effects, the same effects we see in in the public markets?

But, there's hurdles I think we have to overcome from an education standpoint. That's why I'm excited about this podcast today, Christine, with Scott here. We have to think about liquidity or illiquidity. How do you think about that in a portfolio that has public and private investments? And I can't buy the index fund of the entire private equity universe. 

So I think a starting point… I don't see any change at a broad level, Christine, of starting someone in a broad-based publicly traded public investments as a portfolio. It's going to serve and has and will continue to serve investors really well. 

Christine: So Scott, help us unpack a little bit the opportunity for investors who could potentially benefit from PE exposure. How do you determine that or how do they determine that? 

Scott: So maybe let's start with who has supported the industry for the last 70 years, and it's predominantly been an asset class where institutional investors have allocated. And when I say institutional, I mean pension funds, endowments, and foundations, more recently some of the largest sovereign wealth funds from around the world. There's a recognition for the individual to say, "Hey, I want to participate in that as well."

But in doing that, I'd say a couple things. This should not be the first place you go in a diversified portfolio. This should be an investor that already has a broadly, well thought-out diversified portfolio. And this is an asset class that has a reason to be part of that portfolio. And it might be 10% or 15% of the program. 

I think it's also important that the investor understand the illiquidity that comes with the asset class. So, if you're going to go out and put a down payment on a house or pay for your child's tuition, this is not the place in your portfolio you're going to go for, for that liquidity. There needs to be a tolerance for duration. 

The last thing I'd say, and this is kind of just part of the fundamentals of investing — you shouldn't invest in something that you don't understand. 

Joe: I certainly hear you. But let's say, I know what it is, but I'm not in the private equity space. So what would be the next click, do you know what I mean? Help me out a little bit more. 

Scott: I mean, it's more broadly defined, and we can go down different paths here, but within private equity there's different strategies. There's venture capital, growth equity, leveraged buyout. And just briefly to describe those, venture capital is probably the riskiest place to allocate. It's investing in an entrepreneur and an idea at the company formation stage. Those types of outcomes are binary, but if you get in the big winner, it drives a lot of performance. 

Growth equity is interesting. This is typically where it could be a founder that bootstraped their company and has grown that company to be millions of dollars in revenue or maybe in tens of millions of dollars in revenue. But that asset has become the dominant part of that entrepreneur’s net worth and at some point they need to think about diversifying and doing estate planning and allocating. But they also want to bring in somebody to help to scale that company to the next level. So that's a growth equity deal.

And then a buyout transaction is where change of control happens. It could be the same founder that we're talking about on the growth equity example, but they get to retirement age, and there's no heir that's going to take over that company, and they want to monetize this asset that they built over the last 30 years and private equity can step in.  

Joe: You tell me — so really high returns and then almost defaults or insolvency. Would that move from left to right as you went through your progression? 

Scott: It would.

Joe: Because it implies risk. That's the risk that we’re talking about.

Scott: That's right. So dispersion is greater in private markets than it probably is in the public markets, at least the broader public markets. But you're correct as I walk through those examples, the dispersion, meaning the higher highs and the lower lows, is greatest adventure, then growth, and then leveraged buyout. And that's both opportunity and risk. 

If you get it right, you can materially outperform the benchmark, but if you get it wrong, you're going to pay the price, which means you've really got to spend time. 

Joe: That's helpful.

Christine: So, Scott, some managers now offer semi-liquid PE funds. Do they eliminate the liquidity issue for investors? 

Scott: It's a really good question, and in the industry, these are called evergreen semi-liquid, — sometimes both terms used together. And the reality is evergreen has existed for a long time. But when institutional investors were investing in the asset class, that was not a solution that they were asking for. They were comfortable with what's called the closed-end drawdown fund, where the manager that you're giving capital to actually controls the drawdown and investment pace of the capital. 

In that scenario, the investor gets time diversification and new company investment that could be four years. It could extend it to as much as six or seven years. 

Where semi-liquid, evergreen has become very much top of mind is as individual investors come into the asset class, they want a package or a structure that feels similar to their public equity portfolio. And with evergreen semi-liquid, they can invest, they can be more fully funded at day one, sometimes 100% funded at day one. And then the semi-liquid feature means the fund has a redemption right. So, typically the governor on redeeming is 5% of NAV per quarter. So if you have $100 of NAV over the course of a year, you can draw down 20% of that NAV. 

And I think this is just a package that's been more conducive to this newer investor coming into the asset class, to get them more comfortable with the illiquidity that we're spending a decent amount of time talking about. 

It's something that I think the individual investor market is asking for or demanding, because it just feels more like the things that they're used to.

Christine: So Joe, Scott has laid out the opportunities for investors, but it's not all opportunities. There are trade-offs, as this title of the episode suggests. Can you talk about some of the downsides? 

Joe: It's just around the active manager risk. And because I cannot buy the entire "haystack," as Jack Bogle used to call it, I can't buy all the companies, as Scott mentioned, that's good and bad, right? Because there's lottery-sized tickets out there, the unicorns that you're hoping to capture in these funds. 

So that is good. That's the allure, if you can find it. But that's why implementation is really important. I can't stress enough the due diligence of the manager and of the skill, and then the cost to drive down, because I need the net return. I care less about the debate of how much the illiquidity premium will give me in the private markets. 

Why I say that is because the dispersion of the actual vintages in these private markets are so large —I've sat on investment committees, I've seen negative 42% returns and positive 75% returns above and below that ledger line. That's true in public equity active managers, it's certainly true and the only option path for the private markets. It’s the active manager risk, which again, is both the allure, as well as the caution, of these investments. 

Scott: So another first-principle investing, it's cost averaging. So, investors that decide that they want to have private equity in their portfolio should be very consistent by vintage. 

Joe: You would say that vintage is key — diversification through time. 

Scott: That's right. 

Christine: And Scott, you mentioned vintage earlier — and when you say that I think of wine or fashion — can you clarify what you mean by that in this context? 

Scott: Yeah, it means if today I decided I wanted to have a private market allocation in my portfolio, I should build up to that allocation over time. I shouldn't go in all at once right now. If it's $100, it's $25 this year, $25 next, $25 the year following, at that point, your capital starts cycling, and you have to recycle it and reallocate it back into the asset class. And, depending on what you want in your portfolio, that will kind of dictate how you invest beyond that. 

But being consistent every year on allocating — you could fluctuate a little bit up and down — but just be consistent. 

Christine: Let's talk about performance. When you talk about private equity, for people that are not fully immersed in it as you are or Joe is familiar with it, it feels very opaque. It's very hard to get a full picture of a performance. How do you go about that? 

Scott: So at the fund level, the question of — can I trust the performance that I'm seeing in my financial statement that comes out quarterly — there are best practices on how to value portfolios quarterly. So every fund that we subscribe to has a valuation policy. We're going to use either last round of financing that might be current and therefore it's a true current market value or if there hasn't been a financing that's happened recently, let's look at the fundamentals of the company and go to the public markets to find out what the comparables in the public markets are trading at. 

So, as an investor in these funds, there's often also an advisory committee, which includes a valuation committee. So that manager will have, typically, some of their largest investors around the table, and they disclose the valuation methodology with their auditor on the phone to walk through line by line how they valued each of the companies. And in the public comp scenario, you'll see the comps that were used in doing that valuation. 

Joe: And just to build on that, Scott, because there's some poignant points there. Again, from a macro or asset allocation perspective across multiple assets, I know there's a typical focus when researchers or advisors talk about risk, they talk about volatility. In other words, the up and down of the price of the return from quarter to quarter, standard deviation, that's volatility. I think what we're talking about is having a framing with risk, meaning dispersion. 

 I think dispersion within the investment universe is potentially more important than just volatility from quarter to quarter from these investments. But that's typically how the industry has characterized public versus private. "Oh, there's diversifier" — privates are diversifiers, means they have lower volatility from quarter to quarter. And how do I think about that from a portfolio context? Because I think what this gets to is: What weight should it be in my portfolio? 

This is where, I think in many respects, the approach we've taken at Vanguard and my team is — it may be fairly unique, but we have high conviction in it — and that is you have to do two things really importantly: one is, let's not 'model' or just look at the aggregate return of the entire space. And then secondly, let's look at the individual strategies, either a pool of them — individual manager or a fund of funds of them, and look at that. 

When you do that, relative to the index benchmarks that you may have access to, then you will see because of the dispersion, if you assume that persists, you either get "optimal allocations" for an investor, say, in my personal situation, everywhere from zero because they're below median performance to sizable allocations, potentially above the 15% that Scott was mentioning. 

Christine: So what about relative performance? 

Joe: Relative performance. So if you look back over the past decade or so, let's say the S&P or the U.S. stock market, roughly 12% or so — help me out with the median, what's the PE median?

Scott: Call it 14%–15% or so.

Joe: So, 14%–15%, in theory, I'd say that's a decent estimate in real time of what the illiquidity premium on average for the private equity marketplace has delivered over and above the public markets. I think that's an important part of relative performance measurement and role in the portfolio. But it's not even close to the most important in our judgement, in my judgement, and how our approach is. 

And why I say that, Christine, is that we can debate the size of illiquidity premium for the next hour, right? And a lot of smart people are doing that, right? I think it's above 0 because I can't deploy, I can't get my capital back every day, I should be compensated some respective for that. 

But why I say that is whether it's two or three or four percentage points above the public markets, that premium I just mentioned is dwarfed by the dispersion between the top quartile of private equity firms, in regards to what space they are, versus the bottom quartile performance. And that has to do with the underlying securities in the private markets, which they'll display lottery-size effects. A few unicorns, sometimes a lot of unicorns, and then a lot of failures. 

So if you said the medium was 14%, great, but I can't buy the 14%. If I got the 8% return, what do you think the optimal exposure was? It probably was zero. So that is how we approach it. You’ve got to think about it at the end, is it secure? Which is why the education and the manager selection is so critical. 

If you get a number of those bottom quartile, Christine, you're just really going to drag it down, right? I mean, it's the same way in the public markets, and that's why some of the best active managers, if they have skill, they can have significant outperformance, can overcome certainly their cost hurdles for a long time. 

Scott: And there is academic research that shows persistence and performance among the top private equity firms and venture capital firms. So, even as a new entry into the asset class, you might quickly figure out, "I want to be in those funds," but they have a very loyal investor base, institutional and now more recently individual. One of those investors has to step back in order to make a place for a new investor to step in. So you may have figured out you want to invest here… 

Joe: It’s access:

Scott: Yeah, it's just not available to you. Access is critical. 

Joe: Maybe I'm too simplistic, it's not just cost and skill, but within that skill is: Can I get access to the skill? Maybe, but there's potentially new skilled managers firms coming to the space at the same time, right? 

Christine: So, Scott, Joe, as always, we've covered a lot of ground. What would be some of the takeaways that you want to impart for those that are interested in this space now having heard from the both of you, what do they need in order to feel confident in participating? 

Scott: Be very thoughtful about how you build out your portfolios. You should not start with private markets, it's in addition after you've built out probably a broadly diversified public market portfolio. Look, you'll get some benefits from that, because in some ways private and public are non-correlated, so that diversification is critical. 

You should invest and underwrite fundamentals and try not to speculate too much on how you do it. So, if you're investing in a company that's a private company or you're investing in a manager, there are frameworks that prove to be true over time that you should rely on. 

And then, you do need to really understand the asset class, so you're not surprised.

Christine: Joe, anything to add?

Joe: I think there's a need for greater education across the board. I think there's a greater education needed for how much "liquidity" do I need in my portfolio. And that's on both sides. We’ve got to think seriously about manager risk and the cost of this space and the transparency and how do we adjust for liquidity for the overall portfolio. There's risk, but there's also opportunity, potentially, in this space. 

Christine: Thank you so much, Scott, Joe, thank you for helping us understand the world of private equity, the opportunities, as well as the trade-offs. We hope that we helped you understand what you need to consider if you're interested in getting into this space. Thank you for joining us. 

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