Private Equity

Private Equity Growth at the Expense of Hedge Funds

Within the “alts” universe, dollars are increasingly flowing to private equity compared to hedge funds. Stuart Hastie of BMO Private Equity offers a compelling theory as to why – while adding insight on how to find the best strategies and managers within the space.   
January 2020

Stuart Hastie

Director, Private Equity

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Within the “alts” universe, dollars are increasingly flowing to private equity compared to hedge funds. Stuart Hastie of BMO Private Equity offers a compelling theory as to why – while adding insight on how to find the best strategies and managers within the space.   

Rebalancing From Hedge Funds to Private Equity

A recent report on institutional portfolios underscores two trends that all investors should be aware of: First, allocation to alternatives (or “alts”) has more than tripled in the past decade, rising from $3 trillion to $11 trillion.1 Second, investment dollars within the space have swung from hedge funds to private equity, among other areas, making it the single largest destination among alternative asset classes.

In particular, the report shows AUM for hedge funds declined seven percentage points between 2018 and 2019, while at the same time private equity’s slice of alts grew from 18% to 25% – a seven point increase.1 Though correlation does not equal causation, it’s fair to assume that some of the redemptions went toward private equity (PE), in addition to infrastructure, real estate and private credit.   

Under the Hood: A Look Behind the Shift to PE

When looking at how PE has performed, investors must be careful. It’s a long-term asset class with relatively rigid structures, so there’s no guarantee an isolated year will accurately represent its true performance potential. Case in point: partnership vehicles, which provide exposure through a joint investment approach, typically have a minimum life span of 10 years – a holding period that enables them to deliver higher returns through an illiquidity premium.  

Over the long term we look for PE to outperform publicly-listed equities. If the stock market generates approximately 8%, which it typically does, we’d expect PE managers to deliver annualized returns of 15% to 20% per annum. While some hedge funds are capable of achieving similar results, the fact most are open-ended makes it easy for investors to exit if they are unsatisfied.

Investors have not been happy with hedge fund performance. Only 55% feel the asset class has met or exceeded their expectations for annual returns, whereas for private equity that rises to 94%.

Looking ahead, we expect these trends to continue as investors re-position their portfolios ahead of the late cycle. Rising uncertainty often drives asset managers to reassess parts of the allocation that haven’t done well, and in recent years that’s included the vast majority of hedge funds.

Outliers do exist; however, generally speaking investors have not been happy with hedge fund performance. Only 55% feel the asset class has met or exceeded their expectations for annual returns, whereas for private equity that rises to 94%.2 This, combined with an overweight exposure to the sector, may be what’s responsible for investors choosing to divert assets elsewhere.

Rising Competition for Hedge Funds, But Not for PE

Ease of replication is another factor driving this rotation. Hedge funds used to broadcast liquidity as a core differentiator, but now ETFs offer similar advantages at a fraction of the cost. By contrast, private equity does not have a comparable asset class; its characteristics are much harder to duplicate, whether that’s the lengthy time horizon or unique deal flow.

Consider a few of its idiosyncrasies – companies are held for four to five years between the purchase and point of sale; a willing buyer must be found to enter or exit some structures, creating competitive tension for the managers; and the fund life is extendable to buffer against recessionary environments. How many asset classes have a similar profile? 

While both industries charge fees to cover overhead expenses and day-to-day operations, the kicker is how they incentivize potential upside.

While it’s true that hedge funds offer greater liquidity, they are often at the behest of macroeconomic conditions. A falling stock market today can negatively impact their ability to deliver exceptional returns (short positions are not a given simply because it’s a hedge fund), whereas stock market volatility matters much less for PE, given the longer time horizons. This is not to say there’s no correlation, but having greater ability to time an exit point helps insulate the portfolio from near-term risks.

We find this an important point to emphasize, because one of the main challenges of PE is its illiquidity. Investors typically prefer the freedom to move in and out of their positions – however, as stated above, the lengthy time horizon generates a valuable premium. As investors can get more comfortable with alts being a long-term play, we think growth in this area could continue.

Different Pay Scales Create Opposing Outlooks

A final distinction is how remuneration is dispensed in each field. While both industries charge fees to cover overhead expenses and day-to-day operations, the kicker is how they incentivize potential upside. PE firms usually pay performance fees based on a whole fund basis, whereas hedge funds tend to have high-water-mark mechanisms that put a lot of pressure on the manager to optimize AUM within the year. It’s a shorter-term mindset.

Comparatively, the role of a PE manager is much more involved. You have to meet with the acquisition target’s executive team and negotiate a price for assets that are not in the public domain. You may spend days, weeks or often months trying to get under the hood of their business, learning what makes it tick, so you can arrive at a valuation that’s fair and reasonable to the sellers. Then, in order to exit, you must genuinely add value and gather momentum toward an IPO or re-sale to a bigger PE shop.

As with most alternative asset classes, the differential between top and bottom quartile managers is significant.

In its purest form private equity aligns investors’ interests with those of the management team. The idea is that everyone has a stake in improving the business, especially when it comes to buyouts in the lower mid-market space, where enterprise values are typically $250 million or below. Many of these businesses have been owned by a single family for generations, and are extremely generative in terms of profits. What they lack is an ability to reach the next level, to internationalize, or to build out in new directions. An effective manager can give them the keys to success during the years they are held by the private equity house, bringing all sides together to grow the business.

The Qualities of an Exceptional PE Manager

When looking for the RIGHT private equity manager for your portfolio, you should first consider the corresponding risk and return profiles of various approaches. For example, a fund-of-funds offers risk-averse investors a suitable entry point to the market, holding a portfolio of other investment funds rather than investing directly in individual companies. At the other end of the spectrum, a direct fund concentrates on a single manager, raising the potential for upside gains while also increasing risk. Co-investment funds, or funds that offer a co-investment element, hover between these two ends, consisting of a well-diversified pool of companies, sectors, geographies and lead managers – bringing together the best elements of both.

Next, you should look for managers that are in, or entering, their prime. These are experienced private equity professionals, most likely in their 40s, who’ve worked for a big PE house before, and are now looking to start their own brand. We find they offer tremendous value because not only are they capable and professional, but they’re also highly motivated to make their new outfit a success. In our experience, that alignment bodes well for a strong performing fund.         

As with most alternative asset classes, the differential between top and bottom quartile managers is significant. Those in the top decile can produce significant annualised returns –30%+ per annum is possible – whereas the latter should be avoided in order to preserve your principal. In general it’s dangerous to take a broad view of the industry, especially given that public perception is shaped by press coverage of high-profile managers rather than those which are most effective.

Now it’s on our shoulders, as advocates of the asset class, to try and explain to the public that we’re not going to work financial engineering magic on these companies.

Media outlets also tend to focus on the individual wealth of senior executives, which goes back to the financial crisis and widespread concerns about the use of leverage. As an ex-banker, I remember looking at private equity investments with 10% equity and 90% debt, worried as to how they would possibly survive the impact of minor interest rate increases. Many of those PE houses precariously balanced, but ever since then the industry has learned some hard lessons in terms of how to structure deals.

Now it’s on our shoulders, as advocates of the asset class, to try and explain to the public that we’re not going to work financial engineering magic on these companies. Our approach truly is focussed on seeking out and helping businesses become stronger and more resilient, so they can boost employment, increase revenue and improve profitability.

BMO PE: Our approach – and our niche

We at BMO Private Equity focus on the lower mid-market space because most of the value creation in that area comes from earnings growth. Analysis we have done on our portfolio of private equity investments shows that only around 10% of the value creation is based on leverage. Most of the value creation comes from extending top and bottom-line growth for private businesses, taking them to the next level of their development.

Owners of these legacy companies are often deeply entrenched in their community, with some even living in the same town where the business originated decades ago. They do not want to sell to someone that tarnishes their reputation, because they have to go on living and socializing with those who will be impacted. Their motivations are layered; so, it’s important these businesses are not irresponsibly levered – we typically observe a 50-50 split between debt and equity for the underlying company, with debt at around three times earnings.

Our goal is to establish a true picture of the manager’s ability and character, so that our investors gain access to the upper crust of private equity.

In addition to standard fund investments, both primaries and secondaries, we have successfully completed over 70 co-investments since our inception, because we find there is growing appetite for funds that deliver a value-added approach. Regardless of whether you’re trading in the primary, secondary or co-investments space, private equity investors should, in our opinion, expect long-term returns of approximately 15% per annum.

Finally, we prefer investing with PE houses that have a cohesive atmosphere. Though our ultimate priority is to identify the most capable individuals, we tend to steer clear of over-bearing personalities. Our due diligence goes beyond their track record and expertise; we’re looking to see if they can be candid about past mistakes, because nobody has gone through a full career in this business without making a few. Are they comfortable with transparency? Can they acknowledge an error? Do we trust their ability to continuously learn? Our goal is to establish a true picture of the manager’s ability and character, so that our investors gain access to the upper crust of private equity, now the preferred destination of alternative asset classes.   

 

To learn more, please contact your Regional BMO Asset Management Institutional Sales & Service Representative.

 

Also in the Winter 2020 Issue of IQ:

A Passive ESG Strategy to Meet Growing Demand

The Dawn of a New Decade: What’s Next?

 

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Disclosures

  1. James Langton, “Hedge funds out, PE in, survey finds,” Investment Executive, November 13, 2019.
  2. Ibid.

 

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