Providing Access

June 2, 2008

Imagine for a moment that you have been fortunate enough to develop a portfolio worth between $5 million and $30 million in assets and you are searching for the right advisory relationship to both protect and maximize your hard-earned wealth. According to the 2005 Merrill Lynch/Cap Gemini World Wealth Report, you would be referred to as "midtier millionaire," and the wealth management industry is scrambling to address your segment. Whether you seek pure investment guidance or broader wealth management solutions, that size of portfolio should certainly be large enough to allow you entrée into the best alternatives, shouldn't it? Unfortunately, it does not. Many wealth management firms work only with the upper end of that portfolio size, and most will tell you that there are many investment choices, like hedge funds, venture capital and private equity, that are either unavailable or too layered with fees (more on that later) to provide incremental benefit to your portfolio. In short, you've been shut out of the kinds of returns and diversification enjoyed by successful institutional investors like the endowments of Yale, Harvard and Stanford University.

Savvy investors have long known that the returns in buyouts (a subset of private equity) dwarf the returns of the public markets specifically because the rewards from these offerings involve two risks that most investors completely avoid: liquidity risk and non-systematic or business risk. The wealth management industry has done a very effective job of focusing investors on the avoidance of risk and achieving more balanced portfolios, but in many cases this has been done at the expense of higher returns. More recently, the general public has become aware of just how compelling these returns can be with the public offerings of The Blackstone Group and Kohlberg Kravis Roberts & Co. and their historical results of better than 20% per year.

Indeed, David F. Swensen, chief investment officer of Yale University's $22.5 billion endowment has allocated nearly 20% of the assets of his institution's portfolio to this asset class for many years, and his performance of 17.8% per year for the last decade outpaces those of all his peers, including Harvard University, by nearly 3% per year. In Swensen's seminal book on investing, Pioneering Portfolio Management, he outlines the case for strategic asset allocation, rebalancing, rigorous due diligence and, importantly, the inclusion of alternative asset classes (with a full understanding of the risks involved). Not only have his peers in the endowment world followed in droves, but the largest U.S. public fund, the California Public Employees' Retirement System (CalPERS), reports having invested more than $11 billion in private equity, having earned 33% more on these investments than on its public equity holdings.

Swensen does not advocate the position that investors should look to Wall Street to address this lack of access. In fact, he's been openly critical of the practices of paying fees for active management, 12b-1 fees in mutual funds, conflicts of interest at investment banks, as well as a host of other potential abuses of the public trust.
Large family offices, ultrawealthy individuals and institutional investors like these endowments and public funds have enjoyed these excess returns for years (See figure 1).

Given the more recent turbulence in the public equity markets, and the reasonable statistical probability that large-cap U.S. equities are trending toward 0% returns for this decade, these alternatives become even more compelling now. While the average investor has a very different risk profile and time horizon than Yale University, the college's portfolio strategy would be a boon for anybody in tough times-since its approach has allowed it to use 33% of its endowment contribution for operating purposes, an increase from 10%.

If you're the midtier millionaire discussed in the first paragraph, you have more complex needs than most, but find yourself below the minimum requirements of family offices and multifamily office advisory firms and many specialty private placements. Oftentimes this group of investors receives either watered down or fee-laden versions of the asset classes that institutional investors like Yale and CALPERS employ, and end up with a place holder of sorts for this part of their portfolio.

These fund-of-fund investments often miss the outsize return opportunities of the purer institutional classes because of the extra layers of fees added to them by their providers. Because private equity and hedge funds have higher fees and different fee structures than traditional asset classes, any additional fees add up very quickly for their investors. In periods of subpar performance, these additional fees bring the returns of these packaged investments more in line with traditional portfolios. The sponsors of the packaging argue that the fees are justified so that they can perform due diligence, manager selection, performance monitoring and other protective measures, but the curtailed returns are still unavoidable. Indeed, protecting investors from unscrupulous, inexperienced or poorly performing managers is a very good thing, but at what cost? A practice that benefits investors by reducing or eliminating these risks by substituting a different risk (i.e. performance risk) should be well understood by investors. Sophisticated investors should have all of these issues laid out before them, including the fees that may well eliminate the opportunities for excess returns.

More effective investors have found that generating dependable and robust returns through private equity investments significantly enhances their more traditional portfolios. In fact, many wealthy families understand this dynamic because they have built and sold a small to midsize business that was the source of their current liquidity. Add to this the common practice in private equity of "eating one's own cooking," where principals commonly have most, if not all, of their liquid net worth invested in their portfolio companies, and the alignment of interest is even more compelling. Thus, they are left with the issue of access, and there are plenty of solutions available.

Many private equity firms that are focused on the lower middle market (deals with $50 million to $250 million of assets) raise funds either on a deal-by-deal basis or through placement agents. To access the former group, you have to be tapped into their network, and there's no central clearinghouse for this particular segment. Further, you have to be pretty deal-savvy, since these are more concentrated investments in individual businesses, and the risk is proportionately higher than a diversified fund of private-equity-backed companies.

The latter group focuses on family offices, institutional investors, and the super-affluent, so the midtier millionaire is still largely out of luck with this group. However, there is hope for individual investors. There are a growing number of firms that raise capital either directly from accredited investors (those with at least $1 million of investment assets) or from qualified purchasers (with at least $5 million of investment assets), and in some cases work through financial advisors as well. Some of these funds provide access to investors at levels as low as $150,000, and are available through registered investment advisors and independent broker-dealer firms. Oftentimes, it is the former small business owner, working either directly or through his or her advisor, that has just the right mix of sophistication and financial resources to be an ideal investor in this end of the private equity market. This covers a pretty large segment of those midtier millionaires, and for those willing to do their homework on finding the right firm or the right advisor, the rewards can be truly substantial.

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