The Private Equity ETF: A Look Under The Hood

Nov.16.06 | About: PowerShares Listed (PSP)

Private equity is a hot topic nowadays. Although big investment companies are the main players, there also is an opportunity for individuals wanting to plant stakes in this market niche. The area is attractive because privately owned companies, spared the burden of having to meet or preferably beat earnings expectations and raise guidance lest their stocks get pummeled, are better able to pursue longer-term strategies. Most of these companies also usually offer better disclosure — those that don't answer all the questions won't get the funding they seek. The road in for individual investors is paved through the publicly traded firms supplying the equity.

The simplest way to jump on the bandwagon is the PowerShares Listed Private Equity Portfolio (NYSEARCA:PSP) exchange traded fund, which debuted on Oct. 24. Its portfolio is not strictly confined to investment firms. The fund holds some companies that have day-to-day operations in other businesses, such as Macquarie Infrastructure Co. Trust (NYSE:MIC), Triarc Companies Inc. (TRY) and Pinnacle West Capital Corp. (NYSE:PNW). The key is that regardless of what other operations a company may have, the making of debt or equity investments in privately held businesses must be an important area of focus.

Whether the PowerShares collection is the optimal vehicle for public investors to participate in this area is debatable. Significant business operations, such as Triarc has with its Arby's restaurant chain, must be accounted for in assessing the stock. There's also the age-old question of which is preferable, payment of dividend or reinvestment of profits into other growth opportunities, which is a less certain endeavor that may cause investors to turn just as nervous and impatient as they are with other publicly traded firms.

Focusing on private equity investments that offer something more distinct from what the average investor can find elsewhere in the stock market, we've selected from the PowerShares portfolio those firms that are primarily investment companies and whose shares offer substantial dividend yields. Table A shows how these shares have performed.

private equity etf

Year-to-date share price performance looks ordinary, although recent weeks have been better, perhaps reflecting investor fascination with the heavy news flow concerning private-equity activity. Recall, however, that we were also seeking income. Table B shows current yields and the consensus Wall Street estimates for year-ahead dividend growth.

private equity etf

When we add income and share price performance, this private equity collection has delivered quite nicely this year.

Even so, we see in Table C that analysts are, generally, neutral toward this group and cooler than they are toward the S&P 500.

private equity etf

One factor may be the grain of salt that must be applied to the second part of the phrase "private equity." Often, the investments are not really equity but privately placed debt which raises associations with "junk bonds."

That's not necessarily a bad thing. Before that field became so notorious about 20 years ago, many early stage businesses depended on debt supplied by commercial banks rather than public capital markets. A substantial, though less publicized, segment of the junk bond market grew to fill a void that arose when banks started to pare back their involvement.

But junk bonds — the sort held by "high yield" mutual funds — are subject to regulations applicable to publicly traded securities. Loans made by companies such as those listed in the tables above are more akin to old-time pre-Drexel bank lending. And like banks, some of these companies tend to fund their own operations through the debt markets. That's not meant to negate risk-characteristics normally associated with borrowings. But we do need to keep it in perspective. The debt incurred by companies listed here is more akin to bank capital than to borrowings by conventional manufacturing or service firms.

Another issue is the risk of defaults on the part of investees, which would result in reduced income and possibly dividend cuts by the "private equity" firms.

A recession would likely prove troublesome in this regard. But it's not as if this group would be singled out. Bank stocks would likely be hit for the same reason, and shares of manufacturing and service firms would also be likely to struggle. Allied Capital (NYSEARCA:ALD), which as been around for a long time, has posted five- and ten-year dividend growth rates of 5.06 and 11.86 percent respectively, despite a variety of economic zigs and zags over those periods. American Capital Strategies (NASDAQ:ACAS), has enjoyed a five-year average annual dividend growth rate of 7.26 percent.

Table D shows the returns on equity achieved by these firms.

private equity etf

The numbers are not impressive relative to the S&P 500. But many of these firms are still relatively new. The hope is that over time, as their early investments mature and are supplemented by new ones, the results will improve. The recent returns achieved by some of the older companies give reason for hope. In any case, with most yields in the 7-8 percent range, investors may decide they can afford to be patient.

Disclosure: At the time of publication, Marc H. Gerstein did not shares of PSP or any of the aforementioned companies.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.