CLEARSTEAD PERSPECTIVES: DEMOCRATIZATION OF PRIVATE MARKETS, AND THE IMPORTANCE OF DUE DILIGENCE

November 19, 2024

You can download a PDF copy of this article here. 

AUTHOR:

Aneet Deshpande, CFA, Chief Investment Officer, Executive Managing Director

Mike McLelland, CFA, CAIA, Director, Alternative Investments

Mike Kuebler, Analyst, Research

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Background

The wealth management industry continues to undergo significant change as it prepares for and adapts to the greatest transfer of wealth ever. It is estimated that Generation X (born 1965-1980) and Millennials (born 1981-1996) will inherit a combined $57 trillion of assets by 2045.[1] The so called “Great Wealth Transfer” has a wide range of implications across the entire financial services ecosystem as the needs and expectations from generation to generation differ. It goes without saying, what is required to retain and win over the next generation of inherited wealth extends beyond the traditional approaches employed by today’s investment advisors for today’s clients.

In a recent Bank of America survey, when posed with the statement “it is no longer possible to achieve above-average investment returns by investing solely in traditional stocks and bonds”, 72% of respondents aged 21-43 agreed with the statement.[2] Taken one step further, this cohort of investors tends to favor private market strategies (e.g., real estate, private equity, and direct investments), cryptocurrency, and digital assets.² While the demand drivers are notable for this next generation, interest in private markets remains robust across cohorts with nearly 100% of investment advisors planning to allocate to the asset class in 2024 alone.[3] Still, across the industry, allocations to private markets remain small relative to other asset classes, with allocations of less than 3.0% of an average individual’s total assets.[4]

Meanwhile, for institutional investors, allocations to private markets are also expected to increase with most institutional investors expected to increase allocations across all private markets over the next two years—funded by decreases in public market allocations.[5]

For our part, Clearstead has been a proponent for private market allocations in client portfolios long before the recent excitement over private markets. We have long viewed that private markets serve an important role—in terms of return potential and diversifying potential—to grow and preserve wealth, particularly multi-generational family wealth and for endowments and foundations. So, we view these developments as completely aligned with the resources of our firm and the investment solutions that we have provided, and continue to provide, to our clients so they can meet their unique objectives.

With these trends firmly in motion, the broader investment advisory industry now finds itself at the epicenter of change, while asset managers (the manufacturers of these investment strategies) have now increased their focus on product distribution efforts, particularly into the wealth management industry. The asset management industry continues to point to evolving trends in the economy as catalysts for advisors to allocate to private markets. Notably, public markets are no longer a reflection of the overall economy, where for example:

• • Private companies account for 85% of all companies generating more than $100 million in revenues in the US.[4]
  • US publicly traded companies have declined by 50% over the last twenty-five years.[6]
  • Employment by S&P 500 companies represents less than 20% of total US employment.[7]
  • Capital expenditures (capex) by S&P 500 companies represents just 15% of total capex in the US.[7]
  • Small privately owned businesses account for over two-thirds of job openings.[7]

These data points provide a compelling story for why private markets may be additive to investment portfolios.

Product development has somewhat leveled the playing field in terms of the ability for investors to access private markets, where historically one generally had to meet certain investor qualifications while the traditional drawdown structure of private market funds required investment advisors to have a depth of knowledge generally not found in the wealth management industry.  Newer products such as interval and tender funds allow investment advisors and their clients to access private markets without requiring a more burdensome investor qualification such as being a ‘Qualified Purchaser’. Additionally, these new vehicles allow for near immediate exposure to an asset class, whereas in traditional drawdown structures it may take years to reach a desired portfolio allocation. Though as we often note, the dispersion of outcomes (Fig 1) in private markets (regardless of vehicle choice when accessing private markets) is extremely wide and in-depth due diligence should not be overlooked despite the operational ease or the perception of enhanced liquidity that these new structures claim to offer. Private market investing is tedious and difficult for good reason.

Interval and tender funds are part of an expanding “evergreen” product set (Fig 2) aiming to bring individual investors closer to private markets. Product development is necessary to advance the wealth management industry while leveling the playing field between institutional investors and individual investors. With that said, the details matter as not all products are created equally and negative outcomes are all but assured for investors that forgo detailed due diligence.  

Considerations for Evergreen Private Equity

When considering quasi-liquid vehicles investing in private equity, it is paramount to evaluate the underlying liquidity of the strategy and how that ties to portfolio construction. Liquidity is an important feature of evergreen vehicles that attracts investor and advisor interest. The liquidity component of evergreen funds is a result of structure, and having a robust cash management process is critical for interested investors.

As we have seen through history, liquidity can be challenging to find when investors need it most, which is often referred to as an asset-liability mismatch. In short, it is relatively easy to invest into evergreen funds, but it may prove to be relatively difficult to redeem from them in certain situations. Investors need to understand that most of these evergreen products have the ability to employ “gates” in scenarios where the liquidity of the fund cannot meet the demands of investor redemptions — turning the somewhat liquid into mostly illiquid, while also running the risk of having to sell assets to meet liquidity needs of a fund. This introduces a level of governance risk as an internal fund committee votes on a monthly or quarterly basis, dependent on the redemption cadence, on the allowable percentage of net assets that can be redeemed from a fund. Given these nuances, it is important that investors understand the investor base for these fund structures as the behavior of one investor can have an impact on another investor’s experience.

This contrasts with traditional drawdown funds where investors face less of an asset-liability mismatch between the investments of the fund and the liquidity needs of the investor. Importantly, evergreen structures are not all misaligned in this asset-liability framework, as certain underlying asset classes, such as direct lending, may be better suited in the evergreen structure while others, such as private equity, may not be—more on the latter below.

The portfolio construction of private equity evergreen products is important to dive into so investors understand what they are getting exposure to with these vehicles. Private credit funds generate income on their underlying assets while private equity—whose returns are derived from capital appreciation rather than from income—does not. Fund managers know this and smartly do not allocate 100% of an evergreen private equity fund to private equity assets. To provide the option for liquidity from illiquid assets, private equity evergreen products need clear liquidity management policies and do so by utilizing capital markets solutions as well as through portfolio construction, the latter of which generally is not related to explicit private equity exposure. The private equity (buyout, growth, or venture) exposure of these funds is often diluted by allocations to asset classes such as private credit, or by permanent allocations to cash. While there is nothing inherently wrong with these diversified exposures, investors seeking private equity exposure should understand liquid private equity products are rarely if ever fully allocated to private equity.

Another aspect of portfolio construction is related to allocations to secondaries versus direct, co-investment, and primary investments. Private equity evergreen funds may allocate sizeable portions of the portfolio to secondary investments, especially early in the fund life. This is also part of liquidity management as secondary positions are more mature and will usually generate liquidity faster. While there are several aspects of secondaries that make them a solid candidate for an allocation in any private portfolio, their return profile must be understood in relation to direct/primary investing. Secondaries will often produce early strong returns due to initial pops from purchase discounts and early realizations while direct/primary investing generates higher returns over time. According to Pitchbook peer group data as of Q1 2024, the median multiple on invested capital (“MOIC”) for Global Secondaries funds is higher than the median MOIC for Global Private Equity funds for the five most recent vintage years (2019-2023).[8] Prior to that, you have to go back to 2000 to find another vintage where secondaries outperform. Early on, secondaries can outperform, but generally over the long term direct/primary investing catches up and outperforms.

Another consideration related to portfolio construction with evergreen funds is that new investors are buying into an existing portfolio. Purchases occur at current net asset value (“NAV”) with all previous value creation already captured in the portfolio. For example, the discounts of existing secondary purchases will, in most cases, already be captured in markups to par shortly after the transaction. Secondary discounts are an extreme example but highlight the difference of investing in an existing evergreen portfolio versus a fresh pool of drawdown capital with full value ahead. When looking at evergreen funds, it is important to look at the existing portfolio and understand the life stage of investments and opportunities for additional value creation.

Fees and returns

Evergreen and drawdown vehicles tend to differ in how fees are charged to underlying investors. For a typical traditional drawdown fund, management fees are initially charged as a percentage of capital commitments. This lasts until the end of the investment period, which triggers a switch where management fees are charged on invested capital throughout the remaining life of a fund (aka fund term). After the change occurs, management fees are only paid on the cost basis of unrealized investments. This results in a decreasing amount of management fees charged as a fund realizes investments. In contrast, evergreen products primarily charge management fees as a percentage of NAV, the current value of the underlying portfolio investments (initial cost plus any appreciation). Cliffwater Associates estimates that the average open-ended evergreen private equity fund charges approximately 2.4% of annualized management fees, excluding carried interest totaling ~0.6%. Other open-ended, retail-oriented products for different asset classes have a similar expense profile.[9]  Excluding carried interest, Clearstead models a 1.8% annualized fee for traditional drawdown private equity funds, which is what we could reasonably expect for client commitments to drawdown funds.

Additionally, private alternative strategies often carry a performance fee labeled as ‘carried interest’. For a typical drawdown fund, carried interest is paid to a general partner (“GP”) on realized investments after exceeding a codified return hurdle (aka preferred return). Most investments are realized in the middle years of a drawdown fund’s life, resulting in carried interest looking like a bell-shaped curve. With evergreen products, carried interest is charged on unrealized and realized gains and increases as the NAV compounds over time. Separately, the operational simplicity of evergreen products comes with a price – higher operating expenses than traditional drawdown vehicles. These expenses ensure that an evergreen fund runs smoothly within its regulatory requirements. It is worth noting that as many evergreen funds have been formed over the past three years, most alternative asset managers with evergreen products have offered fee waivers and different share classes to attract investors.

Proponents of evergreen funds will highlight the return benefits of gaining immediate exposure for long-term compounding with the evergreen structure. While it takes time for a drawdown program to get fully allocated/exposed to investments, investors can get 100% of their commitment invested on Day 1 with subsequent compounding in an evergreen fund. While we have seen several studies illustrating an equilibrium return profile when comparing drawdown with evergreen funds over time, a key assumption is that investors of evergreen funds remain rational. This is in contrast to actual investor behavior observed in public markets where the average investor’s returns fall short of actual fund returns, generally due to poorly timed decisions. A recent Morningstar study pointed to a return gap experienced by investors across a majority of publicly traded asset classes between the average dollar invested into exchange-traded funds (“ETFs”) and mutual funds as compared to the average return of those same funds (Fig 3).

Based on a Goldman Sachs analysis comparing evergreen and drawdown fund performance on a time-weighted, total return basis, a 20-year investment program allocating to evergreen private equity funds would generate the same MOIC as a 13-year commitment program to traditional private equity drawdown funds. This assumes that investors do not sell or trim (liquidity or rebalancing needs) the evergreen fund over that 20-year period and do not fall victim to behavioral tendencies that we know exist during times of market stress. That said, the gap between drawdown and evergreen fund performance increases upon extending a commitment program to drawdown funds beyond thirteen years. Goldman also estimates that a traditional private equity drawdown fund can offer an additional 2.25% – 2.75% of annualized net performance versus a comparable evergreen fund that invests in the same underlying assets.[10]

This begs the question – how can we explain this observed outperformance? Private market investors pay alternative fund managers for their ability to gradually deploy capital over time and invest opportunistically within a codified investment period – typically five years for private equity. The timing factor results in traditional drawdown funds focusing on money-weighted return metrics, specifically internal rates of return (“IRR”). As opposed to time-weighted returns that are used by liquid strategies focused on public markets, IRRs are cash-flow and time-dependent. A 2019 vintage drawdown fund that deployed 100% of its capital in the first quarter of 2020 should have different performance metrics than an identical strategy that invested only 50% during Q1 2020 and the rest throughout 2021. In contrast, evergreen fund investors come in at NAV upon investment and do not benefit from the timing capabilities of private market specialists. The typical 2% management fee and 20% carried interest fee schedule (“2 and 20”) can be warranted for top-performing private fund managers who display this timing prowess, and it may be harder to justify paying a similar level of fees for evergreen funds.

On a related note, the universe of traditional drawdown funds is much larger than the evergreen product landscape. Many drawdown funds focus on small, inefficient markets in specialized sectors and verticals, which can amplify the dispersion of returns but prove to be quite favorable for investor portfolios when allocating to first or second quartile performing funds. Evergreen products, as previously described, are allocated across a broad spectrum of private asset classes to maintain a level of liquidity for potential redemptions and this liquidity buffer causes a drag on returns. Coupling this with the middle market and upper middle market skew of a typical evergreen PE fund, the underlying investments tend to be more efficient with less room for organic growth drivers which is likely to lead to below-median returns with less dispersion. As more dollars flow into evergreen funds, we would expect these strategies to generate returns in the form of private equity beta rather than be alpha generating—the latter of which has historically been the goal of investors allocating to private equity. A final point, traditional drawdown fund general partners typically have significant control and oversight of the underlying investments – a critical point in explaining the return dispersion and lack of a beta-like return profile for traditional drawdown funds.

Clearstead’s Approach

This evolution of new fund structures geared towards private markets should offer advisors and investors a wider palette of investments to choose from to meet their investment objectives. The democratization of private investments through these new fund structures should be seen as a positive for those investors who have not previously had access to this asset class. This is not to say that pursuing some degree of illiquidity guarantees positive outcomes in markets. Capitalism creates winners and losers, and private markets are no less prone to this phenomenon than public markets.

Investors who do not meet the burdensome Qualified Purchaser requirements of most traditional drawdown fund structures can welcome the opening of private market opportunities through private equity evergreen funds, but they should do so only after considering the topics discussed here. Institutional caliber due diligence is necessary to separate managers and funds by fund structure and governance, portfolio construction, liquidity management, fees, and past and future drivers of performance— this process is important for understanding what you are buying into. Additionally, all investors in these funds should do so with open eyes and under no illusion of liquidity of the underlying assets inside of these semi-liquid wrappers. These are generally highly illiquid assets, and we would urge investing in even these funds with a long-term mindset with no assumption of liquidity.

We would also reiterate our preference for drawdown structures for longer duration assets such as private equity—while shorter duration assets such as private credit may be better suited in a semi-liquid format—and that evergreen funds should not be viewed as substitutes for drawdown allocations, especially for private equity (fig 4).

Qualified Purchasers and those who can access drawdown vehicles should because of the governance structure, true private equity exposure, capital lockup, and the fee and performance benefits they provide to investors. As with evergreen funds, due diligence is also instrumental in drawdown structures to ensure clients experience the benefits of locking capital up. In addition to due diligence capabilities, advisors with experience and expertise in constructing private equity drawdown programs can be instrumental in giving investors the ability to build out thoughtful drawdown allocations that negate the immediate exposure and compounding benefits of evergreen funds.

Our view is that private markets will continue to evolve and are likely to continue to play a meaningful role in capital formation for the economy writ large. Investors must rely on advisors to be able to formulate a process and articulate the “why” (i.e., why invest in private markets) and “how” (i.e., how to access the private markets). For Clearstead, these are articulated by an institutionalized asset allocation framework supported by a time tested and results driven due diligence process.

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[1] Cerulli Associates, “The Cerulli Report: US High-Net-Worth and Ultra-High-Net-Worth Markets 2021.” 

[2] Bank of America Institute, “2024 Bank of America Private Bank Study of Wealthy Americans.”

[3] Hamilton Lane Private Wealth Survey, June 2024.

[4] Blackstone, Bain & Company, “Global Private Equity Report,” 2023.

[5] State Street, “2024 Private Markets Outlook, From Headwinds to Tailwinds.” April 2024. 

[6] PitchBook

[7] Apollo 

[8] Pitchbook, Q1 2024 Pitchbook Benchmarks

[9] Cliffwater Associates: The Price of Perpetuity: Understanding Fees in Evergreen Private Equity.

[10] Goldman Sachs Asset Management. For illustrative purposes only. These assumptions are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Drawdown fund returns modeled as the approximate historical returns for drawdown funds over the past 10 years. Cash sleeve returns in evergreen fund based on the Federal Reserve’s long-run policy rate; public credit returns modeled as private returns, less long-term historical yield difference between private and syndicated loans.

DISCLOSURES

Any performance data shown represents past performance. Past performance does not guarantee future returns. Current performance data may be lower or higher than the performance data presented. The information provided is intended for investors are qualified to invest in alternative investments and are willing to accept the increased risks and illiquidity for alternative investments. The information in this report is from sources believed by Clearstead Advisors, LLC (“Clearstead’) to be reliable as of the date listed or presented and is subject to change without notice. The views expressed herein are those of Clearstead investment professionals at the time comments were made, may not be reflective of their current opinions and are subject to change without notice. This material is for informational purposes only and does not consider the investment objectives or financial situation of the person receiving this information. A person seeking information about an investment strategy represented in these materials should contact a financial professional to help evaluate as to whether it is consistent with a person’s investment objectives, risk tolerance, and financial situation. The information contained herein or any opinion expressed shall NOT be construed to constitute an advertisement, investment advice, an offer to sell or a solicitation to buy any securities mentioned herein or other financial instruments. This commentary does not purport to provide any legal, tax, or accounting advice. Clearstead disclaims any liability for any direct or incidental loss incurred by applying any of the information in this report. Performance of all citied indices is on a total return basis with dividends reinvested. Benchmarks may be included for informational purposes to measure the performance of investments compared to markets in general. Clearstead is making no claim that an included benchmark is the most appropriate for evaluating an investment strategy.