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Alternative investments are not everyone's cup of tea. There is a spot for these types of investments in many portfolios; but as always, we need to make sure we understand the risks, opportunity costs, and market context when deploying capital in these vehicles – noteworthy for their high fees and long lockup periods.
Private equity (PE) and venture capital (VC) typically express performance in multiples (i.e., 2.3x) or internal rate of return (IRR). There is currently $800 bn spread between VC, Buyout and PE Growth (the main categories of these two segments) funds. As in all walks of life, there is huge dispersion between the good, the bad, and the ugly (managers in this case). The distinction is typically made by ranking them along the above-stated terms, then breaking them into tiers or analyzing the percentile rank (i.e., what % of group managers in focus are better).
Remember, funds get launched, funded, and deployed fairly regularly by managers. Each fund consists of its own mix of investors, holdings (known as portfolio companies), and metrics (including performance) - each considered a vintage. So, gauging a manager’s performance consists of analyzing all the vintages under their management. This process (‘due diligence,’ if you want to sound like you did a ton of work) is not rocket science. Good questions in due diligence include: How do their worst vintages stack up against peers? What macro events could have helped boost their performance? Am I analyzing over a long enough period?
All of that is a pretty standard way of addressing the segment. However, we are in the midst (hopefully at the tail end) of a fed hiking cycle. Actually, the federal funds target rate rising by 500 basis points over the last 14 months is the fastest pace recorded in four decades. Add to that a ‘nailed-on’ recession that has yet to manifest itself and we are in an environment many professionals haven’t ever seen or experienced.
Hence, with short-term rates hovering around 5%, PE/VC Managers have two big problems to contend with. First, there is finally an opportunity cost to contend with. That is, with the ability to get 5% on their money, some investors will simply stop putting more money into riskier investments (stretching to capture yield) while others will look to stay in the space but balk at the lower risk premium on offer (manager return minus risk-free), deeming them not aligned in terms of risk-reward. In either case, some tried-and-true investors will be perfectly content sitting out a few vintages.
Second, managers (and this goes more for Private Equity managers that use leverage in earnest) now have to contend with a really substantial cost of capital. When you buy something levered or with other people's money, there is always a bogey you have to hit. Creditors call it interest and investors call it a threshold. This bogey has gone up on both counts. Hence, managers are now forced to siphon money away from the bottom line to pay for this bogey, ultimately hurting performance, potentially.
Beyond the simple arithmetic, the thing with a bogey is that it ticks away (ever accumulating) in the background - like the national debt clock in Union Square in NYC. This number would whittle away at the performance of your investments and was not something they had to contend with in the recent past.
Let's do a quick apples-to-apples comparison using very rudimentary arithmetic to really drive home the point. If we were to treat a money market account as the single vintage of a manager (MM Fund I) and mimic the terms of the average PE fund, we could expect it to deliver a 1.79x. Not bad. The power of compounding at its finest. And guess what? This ‘MM Fund I’ armed with a Wall Street salesperson with a Rolex and an Amex black card would be touted as a top-performing fund. Why? Because that 1.8x (approx.) stacks up very favorably against the median over the past 10 years for both PE and VC, respectively. In fact, this ‘MM Fund I’ would best all but two of the median PE vintages between ‘08 and ‘17. And if we consider a run-of-the-mill year, 2012 for example, this ‘MM Vintage’ would be only 12% off the top quartile (2.06x).
Source: Pitchbook.
In conclusion, we are looking at some trying times ahead until we find a new steady state after the triple whammy of supply chain snarl, stimulus and fed hiking work themselves out. PE/VC have a spot in some portfolios. But we need to apply critical thinking and ensure we are properly analyzing opportunities. Finding the right manager is possible but it takes asking the right questions, sifting through the data and truly understanding how – as ever – the investment fits in one’s portfolio.
Disclosure
This information is provided for informational purposes only and does not contain investment advice or an offer or recommendation of securities. Connectus Wealth, LLC d/b/a Connectus Private is an SEC registered investment adviser. Investment does not imply government endorsement or that the adviser has attained a level of skill or training.