Why Investing In Private Equity ETFs Is Like Chewing On The Bones

| About: PowerShares Listed (PSP)

Summary

A dramatic performance gap exists between the profits from private equity and the profits from private equity ETFs.

The meaty profits from PE are generated primarily through performance fees — the rewards paid to firms when a deal exits. PE ETFs don't offer enough exposure to these profits.

Income from performance fees is quickly paid out to firm employees, leaving ETFs valued almost exclusively on the basis of management fees and looking like meager scraps by comparison.

As strong advocates of direct private equity investing, we often get asked, "Why not invest in a private equity ETF?" The reasoning goes: ETFs are popular and low-cost, anyone can buy an ETF through a retail brokerage, and ETFs for private equity exist.

The trouble is, a dramatic performance gap exists between the profits from PE and the profits from a PE ETF. Take a look:

THE MEAT

The desirable returns that true private equity portfolios earn are most closely measured by the Private Equity Quarterly Index - PreQUIn. A comparison to the S&P shows PE has consistently been bringing home the bacon.

Investors are tempted to believe that exposure to PE as an asset class is democratized by the public stock offering of private equity firms. Logical to imagine, but an investment in private equity ETFs is more like scrapping for leftover bones. The meat is already gone.

To see what we mean, consider the PowerShares Globally Listed Private Equity ETF (NYSEARCA:PSP), which reveals a dramatically different picture. PSP has lost nearly 60% of it's value since inception (shown here vs the S&P 500):

THE BONES

Why don't the incredible profits from PE translate to profits in the ETF? (i.e. Where did the meat go?)

If you're considering investing in a private equity ETF, you have to understand the nature of the beast inside. ETFs consist of publicly-traded private equity management firms. Private equity firms are lions and there's a simple, but rarely stated reality at play: Lions hunt to feed their own.

The 'pay for performance' mentality is embedded into private equity culture. Private equity firms are set up to reward the people who work there. The most valuable assets at PE firm walk out the door everyday, so firms compensate their talent aggressively to keep them coming back.

We're not knocking it, either. The outcome-driven incentive system is a powerful driver of returns for investors. The key is understanding how incentives play into the firm business model and where they pay out.

As a whole, private equity firms make their money two ways:

  1. Performance fees, called "carried interest" - The massive returns PE is known for generating come from buying businesses, rapidly turning them around to improve performance, and then selling them. Carried interest is the portion of profits (usually 20%) that PE firms earn from deal profits.
  2. Management fees - Usually 1-2% of total investment dollars under management are charged annually to investors who invest into deals through the firm. This is not performance-based.

The talent at these firms are highly motivated by rewards linked to profits when a business is sold. This means, when a deal exits, the bulk of carried interest is distributed to the firm's employees who drove the deal's performance. They hunt, they deliver, they eat.

Because a huge chunk of the carried interest is paid to people putting the deals together (about 40% of carried interest at KKR, for instance), publicly traded PE firms are valued on the basis of what's left - their management fee streams. That value, in essence, is the remaining bones. An ETF, bundling a diverse group of publicly traded PE firms, is a mixed bag them.

Private equity firm valuations have been almost entirely based on management fees, to the exclusion of performance fees.

Dan Primack, Fortune

Without direct exposure to deal profits, the stock is traded based on the PE firm's value as an operating company. The size of the funds under management predict management fees and, in turn, nearly dictate the stock price. To check Fortune's theory, we modeled the assets under management (AUM) for KKR (NYSE:KKR) and Blackstone (NYSE:BX) against their share prices over the last five years. The results were overwhelming: the correlations were 0.94 and 0.93, respectively. In other words, buying the stock of a PE company is betting on their ability to fundraise, not invest.

THE INFLUENCE OF MANAGEMENT FEES

To get closer to deal-level profits, big investors have the privilege of investing in a fund. The old adage, "It takes a fortune to make a fortune" rings true. Minimum investments into PE funds are usually seven figures, limiting access to institutional players like pension funds, banks, and insurance companies, or family offices and ultra high net worth individuals.

Only the very wealthiest can afford the big sums demanded for direct access to private equity funds run by famous names such as Blackstone, Apollo (NASDAQ:AINV), and Carlyle (NASDAQ:CG), which may require a minimum investment of $1m, $5m or more.

Stephen Foley, Financial Times

So exposure to the meat of private equity remains scarce for the individual investor. ETFs don't offer enough exposure to the upside of PE, and buy-ins to PE funds are impractical for most.

The shares and ETFs of private equity firms today may be a good or a bad trade at today's prices, but don't be fooled into thinking these are "private equity investments."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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