It is poorly kept secret within the mutual fund industry that some 75 percent of mutual funds fail to beat the performance of the S&P 500 index in any given year.
This revealing statistic is central to the explosive growth of “exchange-traded funds” (ETFs)-investment vehicles that are tied to the performance of various indices, the most popular being the S&P 500. Public investors today increasingly would prefer to buy, say, an energy-sector index fund rather than pay a manager to wake up each work day and scour the markets for good energy investments.
Add to the growing list of ETTs two new ones, the first already traded, the second in registration with the SEC: Power Shares Listed Private Equity and PowerShares International Listed Private Equity Portfolio.
PowerShares Listed Private Equity tracks the performance of US stocks that can loosely be described as affiliated with the private equity industry. PowerShares International Listed Private Equity will focus on non-US stocks tied to private equity. The international prospectus does not list what the underlying component stocks will be, but a source confirms that the list will include “household names”. In other words, it will track, among many other stocks, the Euronext-listed vehicles of KKR and Apollo, as well as vehicles associated with 3i and Permira.
The list of component stocks for the domestic PowerShares ETF has led skeptics to question whether this product should rightly market itself as offering exposure to private equity. Shadowing this debate is a discomfiting assertion from PowerShare's creators that the domestic ETF has, in fact, outperformed the Venture Economics private equity performance averages going back one, three, five and 10 years. Given the hassle and expense of investing in this asset class, should LPs ditch their sprawling private equity programmes in favor of simple index funds?
The PowerShares private equity vehicles are based on indices created by a Denver-based firm called Red Rocks Capital Partners, Red Rocks is run by Adam Goldman, the former managing partner of Colorado's Centennial Ventures, and Mark Sunderhuse, who was previously with mutual fund company Berger.
The domestic index fund tracks a collection of stocks that range from buyouts-plus-loans companies to more tangential players. The former category includes American Capital, the huge Maryland-based, publicly traded middle-market private equity firm that also provides senior and junior debts to its own and other deals. In the latter category, the list of component stocks is longer. It is debatable, for example, whether SVB Financial Group, the parent company of Silicon Valley Bank, truly correlates with private equity performance. The same goes for Apollo-affiliated Apollo Investment, which only provides debt to private equity transactions.
A source close to the PowerShares ETF says the product was not designed as a “panacea” for private equity-deprived investors, but rather as a liquid, flexible choice for someone who wants exposure to the private market. After surveying the entire universe of publicly traded companies that provide capital to private enterprises, the Red Rocks team discovered that only 35 had market capitalisations of greater than $50 million, and so decided to include all 35 in the index. The index will be adjusted every 90 days.
The team also back-tested the index to see how it performed against Venture Economics data and, keeping in mind that pro forma performance has an uncanny ability to always outperform, the Red Rocks private equity index beat the venture Economics data every year by margins ranging from 1 percent to 8 percent.
More illuminating will be the forward performance of the international ETF, which included several component stocks that have no history, namely the $5 billion KKR Private Equity Investors and Apollo's AP Alternative Assets. These stocks, and the several others that are expected to be components of the ETF, are pure-play private equity vehicles. The KKR Euronext stock, for example, is essentially a listed fund that will invest in KKR deals. In other cases, such as 3i, the component stock in question represents a piece of the GP's management company.
If, in 10 years time, this soon-to-be-listed index fund ends up with a stronger performance than the private equity portfolios of 75 percent of traditional LPs, expect to see the blur between public and private in this industry to become permanent.