In early 2015, I took a step back from our family’s asset allocation and thought critically if it was as efficient as possible. Like most high-net-worth families, we had a very large majority (at the time, 100%) of our assets invested in public equities and fixed income. By researching the typical family office portfolio, it became clear to me that alternative investments are a major food group for the wealthiest families (Figure 1.5).
Why were alternatives, specifically private equity, so popular among family offices? The data speaks for itself.
Over the past 20 years, institutional investors with a high allocation to private investments achieved meaningfully higher returns than those with a low allocation (Figure 1). To quantify that, over the last 20 years, institutional investors with a private investments allocation exceeding 15% achieved an 8.2% average return compared to just 6.4% for those with an allocation under 5%, or a 180 bps outperformance. The full impact of that delta is as follows: $1 million invested 20 years ago with a 6.4% compounded annual return would be worth $3.5 million today; $1 million invested 20 years ago with an 8.2% compounded annual return would be worth $4.8 million today (40% more).
Further, despite its higher risk on an absolute basis, private equity investors are more than compensated with higher returns, as private equity sits at the very edge of the efficient frontier across asset classes (Exhibit 28).
If the benefits of private equity in a portfolio are so obvious, why do most high-net-worth families lack any exposure at all to the asset class? There are six key barriers to entry preventing wealthy families from allocating to the space:
Financial advisor did not recommend
Public securities are highly liquid and feel “safe”
Public securities are covered by research analysts and are easy to understand
Public securities do not have minimum investment requirements
Public securities do not have restrictions with respect to who is eligible to invest
Public securities are easy to manage with daily marks and straightforward reporting
I think that the first barrier (financial advisor did not recommend) is probably the most common reason that high-net-worth families lack exposure to alternatives. A family whose wealth was generated from a private business is likely not financially sophisticated. While the family built something that provided a valuable product or service to the community, they are generally not experts in the intricacies of capital markets. When a liquidity event results in a windfall of investible assets, the family consults a financial advisor to invest this capital.
Our financial advisor had the traditional approach of a stock / bond mix (as do most). This is what his mandate is; to suggest investments outside of this scope would have been shooting himself in the foot. Financial advisors collect fees on assets under management – any assets diverted away from their mandate would reduce their fee stream. Said another way, most financial advisors do not have an incentive to ask questions that could result in their clients allocating funds to alternatives. Their business is about determining the optimal stock / bond mix that will allow their clients to maintain a desired lifestyle through economic cycles while simultaneously growing their wealth and building relationships to ensure that those clients do not take their money elsewhere.
Of course, I’m generalizing here. Once accounts reach a certain size ($50 million or so), solutions tend to be bespoke, with advisors focusing more on asset allocation than on which specific stocks to own within the equity portfolio. But for the typical high-net-worth investor, public equities and fixed income represent the comprehensive universe of options for their capital, and a financial advisor will not be so fast to inform them of a different truth.
Once investors become educated that there are options beyond public equity and debt in which to invest, the second barrier (public securities are highly liquid and feel “safe”) becomes a factor. There is no doubt that public securities are far more liquid than alternatives. Whether there is a formal lock-up (e.g. private equity fund) or just a less liquid market (e.g. real estate), alternative investments can be challenging or even nearly impossible to convert to cash when a liquidity need arises. A fire sale of illiquid assets will result in a deep discount to fair market value at best. And there are few scenarios more alarming to wealthy individuals than the inability to sustain a lifestyle to which they have become accustomed.
That being said, investors can solve for an allocation to alternatives that makes them comfortable. For very-high-net-worth individuals ($5 million to $30 million investible assets), that figure is probably 15-25%. For ultra-high-net-worth investors (at least $30 million investible assets), that figure should creep up to 30%-60%, depending upon risk appetite, liquidity needs, etc.
Let’s do some simple math. Assume there is a family with $20 million of investible assets. They live in an expensive community, travel frequently, and support a few children. They estimate that they’ll need to spend $500k each year (including taxes), and they would like their investments to fully generate this income. Their financial advisor suggests that they can invest in fixed income at 5%, and the balance of their capital can be invested in public equities. They are in the mid-stages of life, so their advisor recommends a 50% / 50% allocation to public equities and fixed income. Assuming all income in excess $500k is reinvested in public equities, this is how their assets perform over 10 years:
How did the family do? Not bad! They were able to spend as they wished, and they still grew their wealth at a 5.7% CAGR over 10 years. This is no doubt a time-tested method that works. But there is excess income being generated, which means that capital could have been allocated to private equity rather than the relatively low-return public alternatives. We can reduce the family’s allocation to fixed income to the point that their public equity dividends will cash flow the funds necessary to achieve the desired income level. This reduction in fixed income and public equity will be allocated to private equity instead. Again, we assume all income in excess of $500k is invested in public equities:
By making this change in allocation, the family was able to increase the ten-year CAGR of their wealth to 7%, resulting in 13% more wealth at the end of year ten. Over longer investing horizons, this spread increases.
Of course, we do not know with certainty how the equity markets (public or private) will fare over a given ten-year period. However, private equity has historically performed much better than the public market alternative in challenging investing periods (Exhibit 12), making an even stronger case to increase allocation to the asset class.
Once investors feel comfortable that they can allocate capital to private equity without significant risk to their lifestyle, the third barrier comes into play (public securities are covered by research analysts and are easy to understand). While public securities do have much better coverage than private companies (effectively no coverage), only large, institutional investors have the capability to make direct investments into private companies. And though some high-net-worth individuals do trade single name securities, this is likely more of a hobby, with most of the “stock picking” delegated to a financial advisor. Public markets or private markets, specific investment decisions are generally the responsibility of a manager rather than the investor.
I personally have a disdain for managed public equities, and honestly, I do not hide this fact from my financial advisor. I continue to employ my financial advisor because of my family’s relationship with him and the products and services his firm offers us because of that relationship. However, public managers tend to underperform the market, so even though there is excellent coverage of public securities, this coverage does not benefit the investor (to be discussed further in a future post).
To invest in private markets, similarly, most investors will employ a manager, typically through an investment in a private equity fund. Manager selection in private markets is extremely important for performance, and while a good track record is a helpful indicator, past performance does not predict future results. It is for this reason, and several others, that we opted to build out our private equity platform utilizing a fund-of-private-equity-funds strategy. Many investors express contempt with this strategy, but I view it as an effective method to build private equity allocation (to be discussed further in a future post).
The fourth barrier (public securities do not have minimum investment requirements) is related to the above. Public securities have a minimum investment requirement equal to the price of a single security. This would generally be less than several hundred dollars for public equities (though in extreme cases, such as Berkshire Hathaway, it could be much higher) and approximately one thousand dollars for public fixed income. Private equity funds on the other hand, rarely have minimum investments less than $100k and often have minimum investments over $1 million. This is another reason why the fund-of-funds strategy makes sense to us – for the same minimum investment, an investor can achieve a diversified portfolio of private equity managers.
The fifth barrier (public securities do not have restrictions with respect to who is eligible to invest) is likely not relevant to investors for whom a private equity allocation is prudent. The Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 requires that investors in private equity funds meet “qualified purchaser” status (note: this is not the case for all private equity funds). This status requires a minimum asset base; however, very-high-net-worth individuals likely meet this threshold.
Finally, the sixth barrier (public securities are easy to manage with daily marks and straightforward reporting) is something to take into consideration. Private equity managers will typically send quarterly statements with investment marks. These statements are sometimes difficult for a less sophisticated investor to understand and are rarely “plugged in” to a broader wealth management platform, making these investments difficult to track. Moreover, private equity funds are typically structured as a partnership, and managers will provide a schedule K-1 for each tax year. These schedules are not nearly as straightforward as a form 1099 that a financial advisor will provide for public securities investing. The complexity of these tax documents will almost certainly require professional tax services that are meaningfully more expensive than they otherwise would have been. Any investor exploring the possibility of including alternatives in their portfolio would need to seriously take these complexities into consideration. Is the outsized performance worth the additional education, legwork, and costs associated with the investment?
As a family, we have limited liquidity needs and are willing to devote the resources necessary to manage a private equity platform. We are very long-term investors, and the 300 to 400 bps of outperformance that we believe is achievable in private markets is very much worth the additional effort to us. Though we’re still early in the lifecycle of our private equity platform, results to-date have been strong, and we’re optimistic about its long-term potential.
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