In a challenging macroeconomic environment where investors are looking for more favourable returns, private equity is becoming a regular feature in UHNWIs’ portfolios. However, it presents far tighter liquidity constraints and a higher risk profile. John Schaffer speaks to private banks and wealth managers about what is making this asset class tick
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The investment industry is finding it increasingly difficult to provide healthy returns for its clients via traditional avenues. Allocations towards alternative investments certainly do present a greater level of risk, but private equity performance has historically outstripped public markets over longer term horizons.
The illiquidity factor of the asset class omits a majority of HNW investors – even if they are to invest via funds. However, even the ultra wealthy may be put off if they are not well versed in the area and are especially risk averse.
However Sylvain Froissard, private equity funds analyst at Societe Generale Private Bank, suggests that private equity has been gaining "positive momentum" amongst UHNWIs:
"Many UHNWIs are quite keen to engage in discussions regarding private equity and to make sure that their practical allocation in the asset class is taken into account."
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By GlobalData"Private equity is going to be key for us in the coming years. The asset class will be relevant for UHNW clients. We really think that in terms of tactical asset allocation, private equity will take some place."
Froissard suggests that the asset class has recovered in terms of popularity from a slump after the financial crisis. He also feels that the current low return environment and turmoil in the equity market is prompting regained interest.
"Post 2008, there was less of an appetite for the asset class due to the illiquidity factor, where everyone was looking for liquidity. But that’s not the case anymore."
Iain Armitage, head of investments at Citi Private Bank EMEA, adds:
"It’s fair to say that following the credit crisis, there was a marked pull back in private equity investment from the broader spectrum of clients who didn’t quite have the understanding and sophistication in the space. This lasted for about 3-4 years and I would say, for the last 4-5 years, pretty much every client that has the knowledge and experience to invest in private equity is back in the market and looking for good opportunities."
However, Armitage says the low return environment is not the sole driver for the asset class.
"If interest rates were higher, I think the interest in private equity would still be as relevant as we see it today."
Armitage also feels that UHNWIs are underweight in their allocation towards the asset class, saying that private equity "belongs in a great deal more portfolios than I see today".
"In general, UHNWIs are under-invested and I think is partly to do with the fear of what happened after the financial crisis because 10-15 years ago private equity wasn’t as professionally structured as it currently is. My clarion call to UHNW clients would be to look at the asset class again, because I believe it has a much better risk/return trade off than people think."
Brad Dorchinecz, director of private equity at 50 South Capital – Northern Trust’s alternatives subsidiary – says that greater knowledge is contributing to more private clients allocating towards private equity. He tells PBI:
"Wealth management clients that we work with are much more sophisticated when it comes to private equity than they were 10-15 years ago. They know the terminology better, the nuances of the asset class, and understand the illiquidity."
Entrepreneurial appetite
Asset allocations towards private equity are particularly popular amongst entrepreneurial clients, as they tend to have an affinity with this type of investment.
Pierre-Alain Wavre, head of the investment office at Pictet Wealth Management, tells PBI that entrepreneurial clients are easily convinced of the benefits of the asset class due to their sophistication in the area. They tend also to be more accepting of the longer time frame required.
"Entrepreneurs are pretty easy to convince because they realise that the stock market price doesn’t always reflect the long term value of the company. They are able to accept the illiquidity, because they know from their own companies that the business can be a bit disconnected from the price in the market."
Wavre adds that some entrepreneurial clients use private equity to assist with their own businesses:
"New entrepreneurs have lately been realising that private equity might help their own businesses. They sometimes use it to seek companies that they could later buy – so private equity acts much like a partnership deal."
Entrepreneurs also tend to have an active involvement with companies, especially when there is a direct investment. Froissard, Societe Generale, tells PBI:
"Most UHNWIs will try to be active investors, especially where there is direct investment.
"It makes sense for them – due to their background of entrepreneurship – to be inside the structure of a company and to help the managers that they will be financing. It’s an important topic for them – to be active and to make sure that their expertise, experience, and background will be used by the management."
Froissard adds that private equity is an attractive proposition for business veterans as well:
"Often entrepreneurs, who have sold their business and stopped for a few years, try to come back into business. One of the possibilities is to be able to finance a new company.
"After a long career as senior executive/entrepreneurs, we have seen a number of clients willing to retain positions in boards of directors of companies. They can be a big asset for a management team to have this type of advisor next to them who can help them design the strategy of the company."
However, when it comes to the direct investment approach, even UHNWIs could be priced out of the market. Iain Tait, partner, private investment office at London & Capital, says that gaining access can be challenging, even via a wealth manager or multi family office:
"Access to the better performing managers is continually a challenge as established firms have, over the years, tended to streamline their investor basis and only work with long-standing relationships. This has gradually raised the minimum investment thresholds to a level that is beyond most UHNW clients’ access on an individual basis, and therefore most of the private money being invested into private equity has been through family offices.
"Wealth managers and multi-family offices have sat in the middle of this conundrum. For several reasons, neither has been particularly successful at placing money in private equity. In theory, wealth managers/multi-family would be excellent aggregators for private equity to pool large sums of private wealth to meet manager investment thresholds and create the requisite diversification across managers.
"However, timing for PE fundraising schedules has historically been a challenge, which has been compounded post crisis as PE managers are extending the time between fundraisings. Historically, PE firms would raise funds every 2-3 years but given fundraisings are taking longer and investors are demanding proven evidence that the manager requires the capital (ie, they have invested a large proportion of the previous fund), fundraisings are now taking place every five years or so."
The trade off between investing in funds and directly investing in companies tends to be dependant on the size of the investor’s wealth. Dorchinez conveys the appetite of Northern Trust’s client’s:
"The smaller clients invest in funds of funds and then once you get a little bigger, they invest in funds directly themselves. The biggest investors have a team of PE professionals that go out and buy companies. But these are really in the $1bn plus area of net worth. Below that, I’d say most are investing in funds."
The Illiquidity deterrent
The most significant challenge of a private equity investment is its illiquidity factor. Many investments can require a client’s’ money to be locked up for 5-7 years and it is not uncommon for some investments to require a 10 year or more lifespan.
Dorchinecz, 50 South Capital, says: "PE really shouldn’t be part of a portfolio if a client needs funds in an emergency, if there’s a big market dislocation, or if they have spending goals where they’re going to need some capital."
Armitage, Citi, suggests that conversations around liquidity are the most common concerns amongst clients and that it is a priority for the bank to make clients aware of the longer time frames involved with private equity. He says that it is also important to make clients aware that they could lose significant amounts of capital:
"These are instruments that can potentially offer double digit returns. But they are also instruments where your principal can be impaired substantially – even to the point of a worst case scenario of losing all your money. That is a key in our dialogue when we talk about private equity."
Risky strategies
Pictet’s approach to private equity is largely focussed on leveraged buy-outs (LBOs). Wavre says that that the LBO model returns 17-20% gross and can make 2.2 times the initial investment over five years. However, he says that Pictet tends to, in the most part, swerve clear of venture capital investments:
"Danger comes from Venture Capital, because everyone wants to have the next Facebook, Google or Uber in their portfolio. Clearly here, the uninformed client runs a big risk. We’ve seen a lot of advisors or intermediaries proposing Unicorns. There were some jobs to be done to explain what the risks were and how markets can change. When you reach that kind of valuation, the upside is rather limited."
However, Froissard suggests that Societe Generale clients are becoming more willing to engage in conversations regarding riskier strategies:
"Most UHNWIs are keen to engage in a discussion regarding venture capital or niche topics. On the venture capital side there is a big momentum in technology, digital apps and start-ups, and UHNWIs try to have that in mind now in their tactical asset allocation.
"There is huge potential and also huge risk attached to it. But a number of our UHNW clients are keen to take venture capital as a topic and integrate it as a diversification factor."
