The largest-ever fundraising for a private equity strategy closed at the end of July, with the Apollo Investment Fund IX attracting $24.7 billion, equivalent to a rate of around $115 million a day.
That hasn’t been due to a lack of competition for assets either. Apollo’s brethren in private equity raised $269 billion in the first seven months of this year, according to alternative assets analyst Preqin, putting 2017 on track to surpass the previous full-year record of $413 billion set in 2007.
What’s more, such demand has allowed private equity managers to increase their fees. Preqin has tracked mean fees for buyout funds rising from 1.85% in 2015 to 1.94% this year, with the vast majority of these funds also charging a 20% performance fee.
In short, then, it should be a good time to own private equity firms. With many of the industry’s largest players being public corporations, it is possible to do so passively too. Few seem interested, though. Private equity ETFs contain just $1 billion of assets, according to TrackInsight. Of that, $425 million of that is housed in an iShares product listed only in Europe. The sector is also shrinking, with redemptions of $250 million so far this year.
So why are investors shunning what seems to be a cyclical boom in private equity? One explanation could be fears that the rush of money into the space is chasing too few opportunities. ‘We are hearing some expressions of frustration with where multiples and valuations are at right now,’ says Matt Portner, associate partner at McKinsey.
According to the consultancy firm, just 25% of the Russell 3000 was valued below the median buyout multiple at the end of 2016, down from 68% in 2008. When Preqin surveyed institutional investors in June, 86% cited high valuations as a primary concern, up from 70% in December 2016.
This is weighing on managers too. Private equity funds ended 2016 with $869 billion in ‘dry powder,’ or unallocated capital.
Other active managers would, of course, love the problem of excessive inflows, and there are good reasons to believe that demand for private equity funds will remain structurally high.
‘The financial crisis opened up a substantial gap between the assets and the liabilities of public pension funds,’ argues McKinsey senior partner Aly Jeddy. ‘That gap has not closed; in fact, it’s worsened.’ He puts the funding gap at $4.3 trillion, and wonders where institutional investors will look for salvation.
‘What we are suggesting is that private markets investing is likely to be the place to which they will turn,’ Jeddy says. ‘We are not making a forecast on returns. But what we are saying is that when we look at the most reputable consultants to the industry, what they are projecting and what they are telling their clients is that private markets will considerably outperform public markets in the foreseeable future.’
Past performance provides some ballast to both claims. Analyzing the returns reported by public pension funds, Preqin found that over the five years to the end of 2016 private equity funds generated a median net annualized return of 11.4%, compared with 9.1% from the stock market and 5.2% from hedge funds.
Preqin also discovered that 39% of institutional investors intended to increase their allocation to private equity, and 56% to maintain it at current levels over the longer term. Of those planning to make new commitments to private equity in the next 12 months, 51% wanted to invest $100 million or more.
Passive in private
So what are the options for those hoping to benefit from all this by owning private equity managers? The largest such ETF in the US, with $299 million of assets, is the PowerShares Global Listed Private Equity Portfolio. This holds the likes of Apollo Global Management, Carlyle Group, Blackstone and KKR, although only 39% of its portfolio is in US names.
The alternative is the comparatively tiny $10 million ProShares Global Listed Private Equity ETF. Rather than invest in private equity managers, it focuses on their listed funds. It therefore owns the Apollo Investment Corporation fund but not Apollo Global Management. Half its portfolio is in North American assets.
Slightly different exposure comes from the VanEck Vectors BDC Income ETF, which targets US business development companies. This again includes the likes of Apollo Investment Corporation, although its $183 million portfolio is highly concentrated, with, for example, 20% in Ares Capital. For all three, however, charges may be an issue. Although their management fees are relatively modest (0.5% for both PowerShares and ProShares, and 0.4% for VanEck) their net expense ratios are inflated to 2.31%, 2.89% and 9.67% respectively once pass-through costs for underlying holdings are included.