Groucho Marx once joked, “I don’t want to belong to any club that would have me as a member.” That’s essentially how ordinary investors should feel about private equity.
Every investor — big or small, ordinary or well-heeled, 12 figure or four — should have equal access to markets. That’s a perfectly banal observation in most contexts, but it’s wildly controversial when it comes to investing. Ordinary investors are routinely denied access to the choicest investments, often based on the patronizing premise that they’re too unsophisticated to participate in some segments of the market. By the time those segments finally open to them, the trades are inevitably crowded and much of the value is depleted. What’s left is more risk than reward.
So it is with private equity. Under federal securities laws, investors must meet minimum income and asset thresholds to invest in private funds, which effectively means private markets are off limits to ordinary investors. Why? Because they’re apparently too provincial to navigate the big bad world of private investments dominated by wealthy individuals and institutional investors such as pensions and endowments.
Jay Clayton, chairman of the Securities and Exchange Commission and my former colleague at Sullivan & Cromwell, rightly wants to remove those barriers. In a meeting of the SEC’s new asset-management advisory committee last month, Clayton said that the SEC is seeking to “promote access and choice for Main Street investors, including more recently focusing on ways to increase access to the private markets.”
A predictable chorus of private-equity royalty, including Blackstone Group Inc. and Apollo Global Management Inc., was on hand to warn about the dangers of letting in the riffraff. Blackstone’s chief legal officer John Finley cautioned the committee that such a move must be “done right.” The Institutional Limited Partners Association, a private-equity trade group, was more brazen about its self-interest, arguing that letting in more investors would lower yields.
They have good reason to be concerned. There was a time when private equity was the province of elite pensions and university endowments, but it has become de rigueur in institutional portfolios and increasingly those of wealthy individuals. Even Vanguard Group, the fund giant best known for its low-cost index funds, announced recently that it would introduce a private equity fund for its institutional clients.
You can credit private equity’s popularity to early investors, perhaps most notably Harvard and Yale’s endowments, which allocated large chunks of their portfolios to private investments in the 1990s and early 2000s and then yelled from the rooftops about their outsized winnings. Private equity had everything going for it in those days. It was a cottage industry with a small number of investors and a huge opportunity set. Valuations were low and interest rates were in the midst of a historic three-decade decline, a gift to an industry that relies heavily on debt. To borrow from Woody Allen, 80% of success was just showing up.
Those tailwinds have since disappeared, and the numbers show it. Private equity has become a bulging multitrillion-dollar industry, valuations are twice what they were two decades ago, and interest rates have been on the floor for more than a decade. The industry has experienced its booms and busts, like the larger U.S. economy, but the current boom is noticeably more muted. The Cambridge Associates U.S. Private Equity Index returned 27% a year from January 1994 to March 2000, the first year for which numbers are available, and 26% a year from April 2003 to December 2007, easily outpacing the stock market both times. Since April 2009, however, the index has returned 15% a year through September 2019, lagging the S&P 500 Index by 1 percentage point a year, including dividends.
Many investors are bracing for even more muted results ahead. J.P. Morgan Asset Management pegs the expected return from private equity at 8.8% a year. AQR Capital Management is even less optimistic, estimating that the return for U.S. buyout funds will be closer to 3.1%, or 1 percentage point a year less than U.S. stocks. No wonder private-equity investors are guarding the gates; the last thing the industry needs is more investors.
That won’t stop money managers from singing private equity’s praises when they’re finally able to sell it to ordinary investors. In Vanguard’s release, Chief Executive Officer Tim Buckley said its private-equity fund would eventually “present an incredible opportunity” for individual investors. How does an investment that routinely charges a 2% management fee and 20% or more of profits jibe with Vanguard’s low-cost mantra? Parroting high-priced active managers, Vanguard head of private investments Fran Kinniry chided, “we’ve gotten so fixated” on fees and “what we really need to focus on is, what does the client get to keep?”