Private equity is all the rage, but should you invest?

Private equity funds are very much the investment du jour — for ordinary investors, as well as institutions. But do the returns they produce justify the hype? As with the clothing industry, fashions in investing come and go, and right now private equity is all the rage. It used to be only institutions and very wealthy individuals who invested in private equity, but it’s increasingly being sold to ordinary investors as well. So what exactly is private equity investing? Essentially, it’s like buying a piece of a company that isn't publicly traded on the stock market. Private equity firms gather large sums of money to buy either a significant portion of a company or the whole business. They then work to improve the company's performance, with the goal of selling it later at a higher price. It’s not dissimilar buying a run-down semi at auction, doing it up and selling it for a profit. Investors can reduce their risk by investing in a fund — usually an investment trust — that will typically include between five and ten different holdings. Is private equity worth it? But is having exposure to private companies really worth it? Well, it certainly has its attractions, particularly as the number of publicly listed companies in the UK and other major developed economies has been steadily declining over the last two decades. The challenge, however, as with investing any other type of asset, is identifying a fund, in advance, which is likely to deliver good returns in the future. Investors are repeatedly warned that past performance is not indicative of future results. Nevertheless, they typically choose funds on the strength of past performance. Arguably, though, past performance is even more misleading in private equity than in public equity. Why? Because funds are valued “offline” by third parties, and only every six months or so. Valuation of unlisted and illiquid assets can be very subjective.

Private equity fees are very high

The single most reliable predictor of future fund performance, as research by Morningstar has consistently shown, is cost. Simply put, the less you pay in fees and charges, the more you keep for yourself, and, generally speaking, the higher your eventual returns will be. The importance of controlling your costs applies just as much to investing in private companies as it does to investing in public ones. There is no other way of saying it: private equity fees, relatively speaking, are very high. There are currently 17 funds of the Association of Investment Companies’ private equity sector, and 11 of them have fees of 1.5% or more. The most expensive fund, by a large margin, is LMS Capital, with an ongoing charge of 4.12%. It has also produced a negative return over one, five and ten years. As of 30th November 2023, its return over ten years is -60.67%. The next most expensive is Abrdn Private Equity Opportunities, at 2.73%. It has performed much better, returning 207.46% over ten years. There are three other firms with charges in excess of 2.5% — Oakley Capital Investments, JPEL Private Equity and JZ Capital Partners. Again, their returns are very widely dispersed. Over ten years, the funds have returned 186.55%, 39.16% and -57.76% respectively. Expressed as percentages, these charges may seem modest, but, compared to fees for public equity funds, they are eye-wateringly high. You should also bear in mind that the AIC’s figures do not include performance fees. Compounded over many years, the impact on investors’ eventual net returns will be huge.

“Not an asset class”

“Private equity is not an asset class,” says Nicolas Rabener, founder of the portfolio analysis fintech Finominal. “It is simple equity exposure in an expensive and illiquid fund structure and is best avoided, especially by retail investors.” Rory Maguire, managing director of the investment consultancy Fundhouse, also urges caution. “In theory this sector is attractive because there are arguably fewer buyers and sellers than in the listed market,” he says, “making it more likely you will find an undiscovered or mispriced idea. “But in practice we find that it is very hard to evidence that any gains make it back to clients. Fees are usually high and opaque. Therefore we tread incredibly carefully in this space and don’t recommend any 100% private equity funds to our clients.”

How returns compare with public equities

Of course, private equity funds will tell you that they aim to deliver outsize returns. But a study published in August this year showed that, since 2008, exposure to private equity has made no contribution at all to the generation of alpha, or excess returns, by US pension funds. Although it is true that private companies used to outperform public stock markets, ongoing research by Cambridge Associates shows that this is no longer the case. As you can see from the chart below, most investors would have been better off investing in an S&P 500 index tracker over the last 15 years than a private equity fund. Private equity vs S&P 500 index

Better ways to gain exposure

For those who do want exposure, there are cheaper ways to access private equity returns than using a traditional actively managed fund. There are now a number of private-equity-themed ETFs available, although Nicolas Rabener points out that these primarily provide exposure to private equity holdings companies, which is not the same as investing directly in private equity. Nor does he expect private equity to replicate the outperformance it used to produce any time soon. "The structural tailwinds of private equity returns were rising valuations and falling interest rates,” he says. “But these winds are now blowing in the opposite direction." Another point that Rabener makes is that if you have already exposure, as rockwealth clients overwhelmingly do, to small company stocks and value stocks, there is little point in investing in a private equity fund as well. “Private equity is effectively a leveraged bet on small-cap value stocks,” he says. “You can replicate that exposure much more cheaply and efficiently via low-cost passive funds."