Private equity’s two and 20 model is mostly accepted as part and parcel of investing in an asset class that aims to deliver outperformance over public markets. To individual investors, even those with several million dollars in investable assets, the model can seem so exorbitantly expensive that they’re deterred from investing in the asset class.
“Many investors do have sticker shock when it comes to investing in private markets,” says Peter Burns, president and chief executive at asset manager Commonfund. Fees tend to be higher than in public markets – particularly for passive public market products, where fees can be so low they’re practically free, he adds.
“Many investors say it just feels too expensive with kind of a knee-jerk reaction. I could buy a passive ETF for almost nothing, and you want me to pay this? It’s a hurdle that some investors won’t get over.”
On a dollar-for-dollar basis, an individual investor’s $50,000 limited partnership stake should benefit from exactly the same economics as a large institutional investor’s $500 million commitment. If the fund makes 2x, net of fees, the pro rata return will be the same for both investors.
In practice, however, an individual investor faces two setbacks. One is that they are often not able to negotiate certain fee breaks, such as on management fees, that larger institution investors can benefit from. The other is that individuals will often be paying management fees to their relationship manager, on top of fees charged by the underlying private equity fund their capital is committed to. Add to that a scenario where capital from an individual investor’s managed portfolio is invested in fund of funds products, and the layers of fees could burgeon to three.
On negotiating fee breaks, some firms have been making progress in helping individual investors benefit from the same discounts of their large institutional investors peers. Cambridge Associates, for example, negotiates fee terms on PE fund investments on behalf of all its clients – be they institutional or closer to the family office type-investor, according to Chris Ivey, head of the firm’s European private client practice.
The firm is also often a “day-one” investor in new funds so it can negotiate favourable terms for its clients, he adds.
“A family client may be investing $1 million in a fund, but because of our scale, they are getting exactly the same fees as all of our other clients… The returns are not any different to what our other institutional clients get,” Ivey says.
More favourable fees or not, PE’s fee model itself is what makes some wealth managers sceptical that private equity exposure is worth pursuing for their clients. For London-headquartered Seven Investment Management, a wealth adviser with more than £18 billion ($24.5 billion; €21.5 billion) in AUM, the risk/reward of private equity does not make sense for its clients, most of whom have between £500,000 to £1 million in investable assets.
“We would think that you could get a lot of the way there by just taking leverage to listed equity markets,” says Matthew Yeates, deputy CIO of 7IM. Any alpha generated over that often ends up being paid away in fees or offset by the liquidity risk associated with the asset class, he adds.
“We’re not really on the fence, we’re pretty negative [on private equity]. It tends to be an expensive to access asset class”
Matthew Yeates, 7IM
For 7IM, which has about $2 billion of exposure to what it considers alternatives – hedge fund strategies, listed infrastructure, some real assets exposure and REITs – a private equity opportunity would have to be exceptionally differentiated for it to be compelling.
“We’re subscribers to the belief that there are papers out there that show a lot of the returns of private equity can be explained as a function of leverage, as a function of a small-cap bias, and by more liquid implementations of equity markets through to listed equity markets,” Yeates says. Drivers of economic growth globally affect both listed and private companies, he adds.
What, then, would make 7IM invest in PE? For Yeates, it would need to be an investment theme that was only available to play through private markets, via a liquid vehicle at low cost, and one with a thriving underlying secondary market.
“We’re not really on the fence, we’re pretty negative [on private equity],” he says. “It tends to be an expensive-to-access asset class.”
For Commonfund’s Burns, the question for individual investors isn’t whether private equity is expensive or not – it’s whether it ultimately delivers alpha. “What we point them to is: we don’t show you gross returns, we show you everything net of fees and net of carry. Are we able to still add value over the public markets? That’s what you should be focused on.”