Prospective clients are sometimes surprised when I tell them we invest in mutual funds and ETFs (exchange-traded funds). Some think we are stock pickers because Josh is on point in discussing companies on CNBC. Others have enjoyed outsized returns in large cap growth darlings Apple, Amazon, or Facebook. But a third group, those with more than $5 million to invest, are hoping for private investments. They want to hear about all the fancy hedge funds and private equity managers we select.
I’ll never forget talking to a client several years ago who had a third of his net worth in private equity. As I presented a globally diversified portfolio of liquid, public investments, he mentioned that he was considering yet another private equity investment because he was happy with his PE returns. I had to ask, had he seen a private equity investment through to the end of its distribution phase? Had he found out the end result of a PE investment? His answer – no. Yet he was itching to commit another $500,000 to a 10-year, illiquid investment.
He loved private equity, yet he had no idea what the returns would be in the end.
Before I continue, let me take a moment to clarify that I am not slamming the existence of private equity. Private equity capital allows small private companies to grow, re-capitalize, merge, or acquire other businesses. This is an important function in the capital markets. Investors who choose to take risk in this type of investment, stand to earn a higher expected return. But higher returns are not guaranteed, and they come at the price of illiquidity and high management fees.
After that conversation, I began to wonder. Would more clients be interested in me if I offered them no transparency, a ten-year lockup, and a 2 and 20 management fee? Could I create a “private” wrapper for my investment strategy? Would that make me more desirable? Today I’m blessed to talk to enough potential clients that it doesn’t matter if we are not a good fit. If I’m not offering what they want, we can part as friends.
But I still can’t help but wonder about the allure of private investments. I think it comes down to one of three reasons.
- Access: People like the idea of having “access” to something that others do not. Investors in private funds must either be Qualified Purchasers or Accredited Investors. Both categories require a high liquid net worth and/or income. Once an investor reaches this level, they have “access” to investments they couldn’t buy before. Bernie Madoff was famous for exploiting the desire to get access. He made it difficult for investors to invest directly in his fund, often limiting approved investors to members of select golf country clubs. We know how that story ended.
- “Better” Investments: Some investors believe that private investments are “better” than publicly traded securities. Not only are mutual funds too pedestrian for this group, so are individual stocks. The fallacy here is that many private investments fail to perform. While in theory, there should be a premium for loss of liquidity and for taking additional risk, higher returns are not guaranteed. Private investments are not “better”, they are more complicated, lack transparency, and cost more.
- Smoothing of Returns: While not an obvious allure, investors in private funds enjoy the shield of daily price discovery. This lack of transparency creates the illusion of lower volatility than public stock markets. Private equity investments may be valued quarterly, but actual returns are unknown until a sale occurs at the end of the investment. While good faith is taken to estimate valuations along the way, it’s nothing more than a best guess until the end. A good comparison is the value of your home. You may think you know what it’s worth, but you don’t until a buyer makes an offer.
Everyone wants to feel special. But feeling special is not a good enough reason to lock up large percentages of your wealth in illiquid, opaque, expensive investments. For the small minority of those with astronomical wealth, perhaps illiquid investments deserve a look. For terrestrial high net worth investors, it’s probably not worth the risk, the cost, the lack of transparency, or the illiquidity.