Mutual fund firms offer clients access to private equity

In a bid for higher returns amid a dismal stock market environment, some mutual fund companies are offering investors access to high-risk private-equity investments.

Just last month, Lehman Brothers Holdings Inc. of New York launched Opta, an exchange traded note platform with three ETNs — one of which tracks the S&P 500 Listed Private Equity Index, which comprises 30 global private-equity companies.

A month before that, Red Rocks Capital Management and Alps Funds Services Inc., both of Denver, launched the Listed Private Equity Fund, an actively managed mutual fund that also invests in publicly traded private-equity firms. In July, Vista Research and Management LLC of Chappaqua, N.Y., launched the Listed Private Equity Plus Fund, which also invests in public private-equity firms.

The fund companies no doubt are hoping to entice investors into their funds with the promise of market-beating returns. The U.S. Private Equity Index, a measure of 690 private-equity funds tracked by Cambridge Associates LLC of Boston, climbed 29.91% over the one-year period ended Sept. 30, according to the most recent data available.

By comparison, the Standard & Poor’s 500 stock index climbed 14.3% during the same period.

To be sure, a handful of mutual funds have dabbled in private-equity investments for years. Those funds, however, have been limited in their participation in the potentially lucrative market by Securities and Exchange Commission guidelines, which impose a 15% cap on the percentage of assets that may be invested in securities that are thinly traded.

NEW WRINKLE

In this latest twist, however, fund companies are able to get around that cap by investing in publicly traded companies that invest in private companies — as opposed to directly in the private companies themselves.

Since a publicly traded private-equity firm may invest in hundreds of companies — across dozens of market sectors — the mutual fund companies insist their funds offer diversification. Others, however, contend that the universe of publicly traded private-equity companies is simply too small to offer any meaningful level of diversification.

“Right now it’s a big buyer beware,” Geoff Bobroff, a Greenwich, R.I.-based mutual fund consultant, said of the new private-equity funds. “It’s a very niche product. Is there enough business out there to get a diversified portfolio and apply investment research to it?”

Investing in private equity is not for the faint of heart. In the quest to earn high-octane returns, private-equity investors must be willing to put up with high-octane risk.

“It can be a bad idea for some people if they cannot stomach that volatility,” said Mark Willoughby, a principal with Greenbaum & Orecchio of Old Tappan, N.J., which has $450 million in assets.

“The question is whether you are getting a whole lot of diversification benefit from it,” he added. “I would argue that you are not. With a publicly quoted company there is still an element of stock market risk that might be similar to the S&P 500 firm allocation that the investor already has in his portfolio.”

Others are skeptical on the grounds that private companies are less transparent, making it more difficult for publicly traded private-equity companies to understand what they are investing in.

SKEPTICISM ABOUNDS

“How do you know what they are investing in?” said Eric Toya, a wealth manager with Leonard Wealth Management of Redondo Beach, Calif., which has $200 million in assets. “Creating the mutual fund is another layer on the whole process.”

Of course, investing in private equity has its advantages, said Kevin Brosious, president of Wealth Management Inc., a fee-only financial planning firm in Allentown, Pa.

“Private equity doesn’t correlate with the returns of the broader market and the returns are as good as the market,” he added. “They’re good investments if they are used properly.”

The minimum initial investment for the Listed Private Equity Fund is $2,500 and the expense ratio is 1%.

“There is a risk element to it,” Red Rock’s co-founder Adam Goldman said of investing in private equity. “But we built a diversified portfolio. It’s less risky because of the broad variety of investments of the firms.

The mutual fund has 40 holdings, which represent about 1,500 private investments, he said.

Vista Research and Management of New York manages the Listed Private Equity Plus Fund, which has a 5.5% load and minimum investment of $1,000. The expense ratio is capped at 1.99%.

It also invests in about 40 companies, which account for more than 2,000 private investments, said Steve Samson, president and chief executive of Vista.

“We are diversified across geographies, industries and market cap lines,” said Mr. Samson. “That’s what we do to reduce risk.”

In a recent study commissioned by Red Rocks, Ibbotson Associates, a subsidiary of the Chicago-based research firm Morningstar Inc., found that private equity has a place in a diversified asset allocation and a reasonable allocation would range from 0% to 10% of a portfolio.

“We believe including private equity should over time improve the risk and return of your overall portfolio,” said Tom Idzorek, director of research and product development at Ibbotson.

The returns generated by private companies are probably similar to those generated by public ones, he added.

“But the upper quartile does much better than the average and the worst does much worst than the average,” Mr. Idzorek said. “There is a large dispersion in their returns.”

E-mail Sue Asci at [email protected].

“Right now it’s a big buyer beware.”

Geoff Bobroff
Mutual fund consultant