When equities are extremely volatile, does it make sense to move to private equity? If you look at the facts, the answer should be simple.
Investing In Private Equity
Prior to determining whether or not investing in private equity is a good idea right now, let’s first take a quick look at how private equity works. In most cases, you will need a minimum of $250,000 to invest. It’s possible to find private equity investments for as little as $50,000, but your upside potential will likely be limited compared to larger investments. Assuming you can invest $250,000, that money will go to a private equity firm. The private equity firm will then likely attempt to follow this pattern: (For more, see: What Is Private Equity?)
1. Buy a company with cash and debt.
2. Manage the company for cash flow purposes in order to make interest payments, pay fees and to pay investor dividends. To generate this cash flow, the public equity firm might have to reduce headcount, cut down on marketing, and/or reduce research and development (R&D) investments.
3. Go public or sell the company.
This process might have potential in certain markets, but that potential is likely to be limited at this point in time. (For more, see: How to Invest in Private Equity.)
Private Equity Headwinds
The first and most obvious problem is that investors have been paying exorbitant prices for private equity for years. And some investors are still overpaying. They’re basing these decisions on what they have seen work in the past. The problem is that all of the best opportunities – or almost all of the best opportunities – are now off the table. Also consider that the private equity firms are selling everything that isn’t nailed down, which indicates they know a bubble has formed. Then you have to factor in interest rates. Even if interest rates don’t move higher this year, they are likely to move higher at some point in the near future. Additionally, you have to consider the risk of tax reform in regards to the elimination of interest-rate deductions. And notice that banks have slowed their leveraged loans in recent months. (For more, see: Effects of Interest Rate Hikes on Private Equity.)
With all of these headwinds, it will be difficult to see private equity offering the same type of returns it has over the past several years. And this doesn’t even take into account a lack of liquidity. If you’re an investor who is interested in private equity but would also like to have a liquid position, then there are two options to consider.
Private Equity ETFs
The following exchange-traded funds (ETFs) aren’t recommendations but ideas for you to research.
PowerShares Global Listed Private Eq ETF (PSP)
Purpose: Tracks the price and yield of the Red Rocks Global Listed Private Equity Index.
Net Assets: $443.53 million
Average Volume: 272,906
Dividend Yield: 8.99%
Expense Ratio: 0.64%
Inception Date: Oct. 24, 2006 (-56.41% since inception)
1-Year Performance: -4.55%
Top Sector Weightings:
Financial Services: 71.85%
Basic Materials: 1.53%
Analysis: As you can see from the all-time and one-year performances, there is a lot to be desired, which is a reminder that you should never immediately be impressed by a high yield. A high yield doesn’t mean anything if there is significant depreciation. You can make a case for the past year when it comes to yield versus performance, but the potential for the next year isn’t likely to be very high given the status of the private equity market. (For more, see: Top 3 Private Equity ETFs.)
ProShares Global Listed Private Equity (PEX)
Purpose: Tracks the performance and yield of the LPX Direct Listed Private Equity Index, which is composed of 30 qualified listed private equity companies.
Net Assets: $15.35 million
Average Volume: 3,075
Dividend Yield: 5.81%
Expense Ratio: 0.60%
Inception Date: February 26, 2013 (+0.37% since inception)
1-Year Performance: -5.51%
Top Sector Weightings:
Financial Services: 84.67%
Analysis: The problem here is a lack of liquidity. While PEX is more liquid than a traditional private equity investment, the volume is exceptionally low, which leads to a wide bid-ask spread. In order to prevent extra costs, you can use a limit order opposed to a market order, but it can still take a long time to fill. (For more, see: Private Equity for Retail Investors.)
Taking on Headwinds
If you’re not concerned with the current headwinds the private equity market is facing and you’re going to invest anyway, then be sure to look out for a few key factors. The first is whether or not your investment will have exposure to a potentially revolutionary technology. If so, will that technology still be revolutionary by the time is hits the market on a broader scale, or will a competitor have time to catch up? Also, who is the management team behind this technology? Are they experts in their field? Do they have a history of success?
If you’re going to invest in private equity and you’re going the traditional route opposed to an ETF, then you should have a long-term investment time frame of at least a decade. Some of the biggest private equity success stories took a long time to play out, which include Cisco Systems Inc. (CSCO), Intel Corp. (INTC) and FedEx Corp. (FDX). Is it likely you will find another winner on that scale? No. Is it possible? Yes. A lot will depend on how much research you put into any potential investments. (For more, see: What Private Equity Investments Are Out There?)
The Bottom Line
The private equity market is peaking as valuations are high and strong headwinds have formed, which doesn’t make it an ideal investment option at this time. That said, there will still be winners – they will be just fewer and farther between than in the past. If you’re looking to invest in private equity without having to contend with a $250,000 minimum investment, or at least $50,000, then you can look into private equity ETFs, which include PSP and PEX. However, neither of these ETFs have performed exceptionally well since their inception. (For more, see: Should My Portfolio Include Private Equity?)
Dan Moskowitz does not have any positions in PSP, PEX, CSCO, INTC or FDX.