Private asset nirvana clouded by recent hedge fund history

Private equity, a relatively new concept for wealthy investors, is being massively hyped by leading private banks during the Covid-19 crisis. Most are seeking increased expertise in this sector, fast becoming a competitive differentiator between those targeting the ultra-rich segment. 

An estimated $5tn is now invested in private equity globally, increasing 10 per cent each year, according to data provider Prequin. This focus on illiquid assets is likely to continue through our contemporary era of low interest rates, with companies turning to private sources for raising capital.

But this is not an easy area to master. It is complex, highly technical and jargon filled. For relationship managers who can “blag” a few stock phrases  on thematic investing or asset allocation, private equity is a step too far, requiring real experience.

The battle for talent in this space has seen a team from UBS walk around the corner from its Zurich headquarters to rival Julius Baer, which is creating a new unit providing private equity and debt opportunities to its ultra-high net worth client base from October 2020. The new operation will offer “access to private market transactions” through booking centres across Emea.

This is a significant development for banks such as Julius Baer, which hope to exploit demand for direct investments, seen as popular among family offices, seeking diversification. Most also seek a window into emerging market megatrends and an asymmetric pattern of returns.

With their emphasis on real companies and industries, rather than financial engineering, this is a relatively easy sell to clients, burned by their previous hedge fund holdings.

“Covid-19 is likely to quicken this shift to sector specialism, as it will become more apparent in portfolio performance and investor returns,” believes Simon Tilley, managing director of Stephens’ investment bank. The banks and managers most likely to succeed are “able to perform deep sector analysis to identify themes, trends and best businesses in certain sectors and then relentlessly invest in those businesses”. 

This scrap for client loyalty is becoming so intense that Didier Duret, an ABN Amro private banker turned family office adviser, calls it part of a “Darwinian race to attract capital”. 

Most private banks expect super-rich clients investing in private equity to sacrifice instant access to capital for higher returns and also follow a “two and twenty” charging schedule, levying clients 2 per cent of invested assets annually, plus 20 per cent of any profits charged on top. 

They are hoping this new revenue stream will overtake their flagging hedge fund business, damaged by gating, black boxes, fraud and undelivered promises during the global financial crisis of 2007-2008.

The latest crisis is causing dislocation in financial markets which will favour certain sectors of the real economy, playing into the private equity theme.

As today’s most popular investment, private equity provides a perfect lens through which to view the machinations of private banks and development of their business models. Not only does it offer access to themes like technology, healthcare and AI, but it can also facilitate investments constructed with environmental, social and governance (ESG) principles.

Concentrated positions in private equity appeal to younger generations’ desire to buy ‘Big Ideas’, compared to evenly-balanced traditional investment portfolios.

In the $30tn intergenerational wealth transfer expected to flow from baby boomers and Generation X to millennials, private equity firms and banks are expected to make ESG a key selling point. Promoting ESG principles within portfolio companies on the ground floor will help players appear more sophisticated amongst Next Gen clients looking for an edge.

“Successive private equity owners have shown their ability not only to support growth but also to be receptive to the needs of company management, who have subsequently become the majority owners of the business,” says Richard Clarke-Jervoise, PE boss at BNP Paribas Wealth Management.

In return for chasing an “illiquidity premium” for long-term investments, banks are rewarded with sweet fees. But there are limiting factors to the portfolio penetration of private equity. 

There is much expectation management to be done by relationship managers convincing clients to switch from balanced portfolios of stocks, bonds and mutual funds. Earnings growth for small companies can take a significant amount of time to generate positive results, meaning investors’ money can be tied up for longer, says Vincent Lebrun, alternatives leader at PwC Luxembourg. 

Further, many PE investors will face increased market risk, he says. “The default risk of the underlying portfolio companies is higher than in a traditional mutual fund, and many of the underlying companies could come with a high debt, which can be costly.” 

Capital risk is also key, with returns vulnerable to lower calibre managers, interest rate fluctuations, and forex changes. While public markets have recovered strongly after significant coronavirus-caused crashes, private companies will struggle in the short-term, according to PwC. It may also take some some time for valuations to normalise and opportunities to materialise. 

More digital access to manager selection and scrutiny will also help popularise the asset class, as will improved reporting and analysis of portfolio holdings, aided by technology. Online investment platforms such as Titanbay, backed by the likes of Morgan Stanley and Bain & Co, designed to widen access to PE funds, are a step in the right direction. 

Experts at Banque Syz point to regulatory hurdles limiting private market penetration of wealth management mandates. The more lucrative deals also typically require larger investments. This means the most attractive opportunities are often earmarked for a small coterie of investors, well enough resourced to conduct extensive due diligence. 

Private equity will probably not match the promises of client engagement and stellar returns promised by its private banking promoters. But we have seen these marketing and distribution machines in action before. When the banks have wanted to fill clients’ portfolios with high-fee, high margin products – which they did to boost profits with both hedge funds and structured products – there was nothing to stop them. The private equity story is unlikely to be any different.