Private equity may not be right for HNW clients

Many high-net-worth and affluent individuals and families have begun following the lead of institutional investors — allocating part of their portfolios to alternative investments such as private equity, venture capital or hedge funds. To satisfy this demand, most major PE firms and many diversified asset managers, such as BlackRock, have been offering “alt” funds to retail investors for several years, and view this as a high-growth category.

But are PE, VC and hedge fund investments the right vehicles for “middle-class millionaires”? Research suggests that, for a variety of reasons, the answer may be “No.”

PE and VC Performance Lags Micro-Caps

Most significantly, research indicates that actively managed value-oriented micro-cap funds tend to outperform private equity over the long-term. Between January 2001 and September 2014, the Russell Microcap Index increased by 219%, compared to 189% for the All Private Equity Index. Micro-cap funds are similarly appealing over the intermediate term and three- and five-year periods, with the Russell Microcap Index again outperforming the All Private Equity Index over these time periods.

Venture capital investments haven’t fared much better. A detailed analysis by the Kauffman Foundation found that VC investments delivered overall poor returns for more than a decade. In its own portfolio of some 100 VC funds, the Kauffman Foundation determined that only 20% of the funds generated returns that beat a public-market equivalent by more than 3% annually. Also, just four of 30 VC funds with committed capital exceeding $400 million outperformed a publicly traded small-cap stock index.

Performance comparisons are complicated by the fact that PE and VC funds use a different method of calculating returns than do stock, bond and mutual fund managers. These alternative investments use internal rate of return, or IRR, instead of time-weighted rate of return, or TRR.

For example, suppose an investor commits $100 to an alternative investment fund at the start of the year. IRR returns don’t begin until funds are requested, so the fund manager requests $10 on Dec. 1. He invests this for one month and earns $1 of returns in December. The fund manager would record a 10% return, which would be an annualized return of over 120%.

Compare this to a mutual fund manager who also receives $100 at the start of the year. If she invests $10 on Dec. 1 and earns $1 in December, her stated returns would be an annualized 1% for the year. This is an extreme example, but it highlights the disparity in comparing IRR and TWR.

The Illusion of Smoother PE Returns

We also find fault with the argument that PE investing by high-net-worth individuals can reduce volatility in their portfolios and smooth out returns. For one thing, many PE and VC funds only value themselves on a quarterly basis, which often occurs 60 to 90 days after the quarter. Thus, the funds only appear to be less volatile than the public markets, which are valued in real time.

There is also evidence that PE and VC funds may engage (consciously or unconsciously) in “return smoothing.” According to a study by Riskdata, funds holding highly illiquid investments, where there is high uncertainty on the price, have, “some discretion in the valuation process and bias can creep in.”

Why Investors Are Drawn In

Despite this evidence, many “middle-class millionaires” are flocking to alternative investments such as PE, VC and hedge funds. This is partly due to the inherent difficulty of comparing the results of illiquid to liquid assets, and the lack of transparency with respect to investment fees and performance.

But another explanation may be that some investors are drawn to the image of wealth and prestige associated with investing in alts. A recent book by economist and Nobel laureate Robert Shiller, “Narrative Economics: How Stories Go Viral & Drive Major Economic Events,” notes that the behavior of investors – as well as consumers, corporations and policy-makers – may be influenced by “infectious narratives.” Think of the persistence of “gold bugs,” the tech bubble of the ‘90s, or more recently, the appeal of Bitcoin. Retail investors may be attracted not only to the financial returns of alts, but also to the narratives of success, status and sophistication associated with the PE and VC world.

A Better Strategy

So, what’s the main takeaway from this? Instead of choosing alternatives like PE, VC or hedge funds, most high-net-worth investors would be better off investing in small-cap securities via index or actively traded mutual funds and exchange-traded funds. Small-cap indices have tracked the performance of PE, VC and hedge funds very closely in recent years. These investments offer the potential benefits of PE, VC and hedge funds without such drawbacks as illiquidity and questionable return calculations. Of course, small-cap stocks should only represent a portion of a well-diversified portfolio that features an appropriate asset allocation based on the investor’s goals.

“Middle-class millionaires” who buy into the narrative of wealth associated with alternative investments may be convinced to add PE, VC or hedge funds to their portfolios. But those who hold less esoteric investments, such as small-caps, may be able to tell a better performance story.

Clark Kendall is President and CEO of Kendall Capital