Listed Private Equity: From Skeptic To Believer

This article was originally published on Seeking Alpha.

Disclosure: I 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

By Jessica Rabe and Robert J. Martorana, CFA

“Listed private equity” sounds like an oxymoron. After all, if a security is listed on a public exchange, then it isn’t private. Even my dog knows that.

Nevertheless, I learned recently that listed private equity does offer many of the benefits of the unlisted variety. And being publicly traded, it obviously offers better liquidity than the ten-year vintages common to limited partnerships.

Background: LPE

Listed Private Equity (LPE) includes publicly traded companies that focus on private equity investments. These publicly traded companies include firms ranging from Kohlberg Kravis Roberts (KKR) in New York to CVC Capital Partners in London. Direct investments in private equity are reserved for accredited investors who can make a ten-year commitment. LPE offers access to direct investments in private equity, with the added benefits of liquidity and transparency. LPE is also available in funds that are diversified across regions, styles (buyout, growth, and venture), and financing types (debt vs. equity). These funds may be available at a discount to Net Asset Value (NAV), and we discuss two of these funds below.

But first, let’s look at historic returns.

Risk/Return Profile of LPE

Traditional private equity has outperformed other major asset classes from 1984 through 2008, as noted in this upcoming study for the Journal of Finance. (I offer the link as a convenience, and not because I have read every word of its 42 pages.) Right Blend Investing has confirmed these return data on the Wilshire Trust Universe Comparison Service (TUCS), which shows the realized returns at pensions, endowments and other institutions. So we are confident that the investment performance is real.

The TUCS data show, however, that the success of a private equity investment is highly dependent upon the manager, and this has resulted in a significant dispersion of returns for private equity. As you might have guessed, private equity is a less efficient market than public equity, so the skill of the manager is critical. In fact, picking a manager in the bottom 5% of the TUCS data would have wiped out all of the return premium for private equity for the latest ten-year period.

That is not a pleasant outcome, so diversification is the prudent route. Fortunately, an ETF or mutual fund offers one-stop-shopping, as well as the occasional opportunity to buy at a discount. Preqin and LPX have studied these discounts, and I highly recommend their 2012 report: Listed Private Equity: Opportunities for Institutional Investors.

This study shows that LPE has traded at an average discount of 7.6% to NAV from 12/31/2002 to 4/30/2012. Moreover, during times of financial turmoil as in 2008, the discounts widened substantially, and listed private equity fell much more than unlisted private equity. Why? The public firms had to deleverage their balance sheets during the crisis, and liquidate investments at fire sale prices.

So LPE is by no means a 100% replication of unlisted private equity. This is nearly always the case with alternative mutual funds, which offer “the black pepper, and not the jalapeño.” (Full disclosure: Rob Martorana is the lead author of Strategic Insight’s 2013 study on ’40 Act alternatives, and the table of contents is here.)

Background: LPEFX

A prominent example of LPE is ALPS/Red Rocks Listed Private Equity (LPEFX). LPEFX are the class A shares of an open-end mutual fund that holds about 30-50 publicly traded private equity companies that trade on global exchanges. The fund was launched in 2008 and has an expense ratio of 2.58%. LPEFX’s top ten holdings as of 9/30/13 are shown below:

private1

Performance of LPEFX

Although LPE often trades at a discount to NAV, the fund provides investors with access to the NAV of the underlying private equity investments, as they have a high correlation. For example, the aforementioned 2012 study by Preqin and LPX shows a 94% correlation in the NAV returns of LPE and unlisted PE. This was based on work done by Michel Degosciu, whom I interviewed as part of my due diligence efforts. Based on his work, there is every indication that investors are able to use listed companies as a means to capture the appreciation in NAV of the underlying private equity investments.

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That being said, the stocks often trade at a premium or discount to the NAV of their underlying investments in private equity. Over the past five years, LPEFX is down 13% since the fund is still recovering from the crash of 2008. More recently, an underweight in business development companies (BDCS) has caused LPEFX to underperform the S&P 500. This underweight has also caused LPEFX to underperform LPE indices that maintain greater exposures to BDCs. (BDCs have done well over the past three years since they offer high dividends, and investors have snatched them up in their hunt for higher yields.)

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Role of LPEFX in Portfolios

Private equity offers the potential for both alpha and diversification, and LPEFX and PSOP allow investors to participate in these benefits without the liquidity constraints of limited partnerships.
High net worth investors or institutional investors can also benefit from these funds, even though they have direct access to private equity deals in limited partnership forms. These mutual funds allow institutions to tactically manage their equity exposure, since LPE enables a portfolio manager to better control the timing and the weighting in private equity. (The timing of investments in private equity are unpredictable, since direct investments involve capital calls that the institutional investor does not control.)

For our clients, Right Blend Investing believes that funds such as LPEFX and PSP are best used as equity complements in the alternatives allocation of a portfolio. For a moderate risk portfolio, we believe that a 20% position in alternatives is appropriate, with 5% in private equity. At the time of publication we do not have positions in LPEFX or PSP, though this is subject to change without notice.

This surge in BDCs has helped broad LPE indices, such as PowerShares Global Listed Private Equity (PSP). From January 2012 to September 2013, PSP outperformed LPEFX by as much as 10%, as shown in the chart above. This performance gap has recently closed, and these two funds are now both up over 40% over the last year.

Looking ahead, LPEFX could start to outperform in an environment of higher interest rates, which might make BDC stocks less attractive. In fact, since September 2013, LPEFX and PSP have converged as LPEFX plays catch up. In similar fashion, the S&P 500 outperformed LPEFX from January 2012 to September 2013, but has since reversed, as LPEFX has been outpacing the S&P 500 (shown in the chart below).

Additional disclosure: All written content is for information purposes only. Opinions expressed herein are solely those of Right Blend Investing and our editorial staff. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. The presence of this article shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any State other than the State of New Jersey or where otherwise legally permitted. This is not a complete discussion of the information needed to make a decision to open an account with Right Blend Investing, LLC. There are always risks in making investments, including the investment strategies described.

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