Private Equity

Private Equity

Hirtle Callaghan manages diversified, multi-fund programs in private equity that include limited partnership interests in asset classes like venture capital, leveraged buy-outs, European leveraged buy-outs, distressed debt, opportunistic real estate, secondaries and "other."  Our diversification includes time as well as type.  That is, we build each client's program over several "vintage years."

Each private equity fund often requires a 7 to 10 year commitment. The only way for an investor to become liquid within the commitment period is to sell into the "secondary market."  This market is made up of investors who expect to capture extraordinary returns by purchasing limited partnership interests from those who, for some reason, are desperate to sell - great for the buyer, bad for the seller.  Consequently, investors should carefully consider liquidity requirements before committing to private equity.  

Why would anyone commit to tying up capital for that long?  Some say for risk reduction.  People in the "private equity business" often tout this asset class as a diversifier.  While there is some truth in that claim, it is often overstated.  Most of the correlation benefit comes from the fact that private equity assets are only rarely "marked to market."  This makes them appear to be far less volatile than public equities, for example, but if they were marked to market every day they would show plenty of volatility. 

The real reason to participate in private equity is simple; private equity can produce returns that are substantially greater than the public equity market.  Although the "average" private equity fund does not beat public market performance, funds that fall in the top 25% of the private equity universe consistently outperform.  This is an inefficient space and a source of what we call "elbow grease alpha" (alpha being a synonym for value added). 

Private equity managers can add value in three ways.  The first is to buy into a company at an attractive price.  The second is to bring real operating expertise to that company - to make it into a more successful enterprise.  The third is to sell at an attractive price. 

Numbers one and three are largely market driven and really beyond anyone's control.  Consequently, we always try to invest with great, experienced operators who are more likely to add value regardless of overall market conditions. 

That is what we mean by a "program."  A professionally managed, multi-fund pool, diversified by time as well as type and carefully constructed over several years.

Private Equity offers Key Advantages to Investors Concerned about Passing Wealth to Future Generations 

Logic tells us that the marketplace is currently paying a premium for liquidity and we want to harvest that liquidity premium when it is high.  We participate in private equity (PE) to increase return, plain and simple. We use hedge funds to reduce volatility and increase compound return, but PE is straightforward. We expect a high-quality diversified portfolio including venture capital, buy outs, distressed debt, etc. to produce 5% more than the public equity markets on average over time.

The 5% premium on average implies that some vintage years are going to return more than others. While it is impossible to know which vintage years are going to be great and which won't, there is one common sense indicator that is hard to ignore. That is, when the market is paying a premium for liquidity, illiquid assets should be more able to harvest that "liquidity premium." This is one of those times. The fascination with liquidity that started with the 2008 credit crisis continues. Logic and discipline insist that we continue to invest in a high quality, systematic program of private equity investments diversified by type and vintage year. This is even more important for family investors.

Private Equity has two distinct advantages that are critical to taxable investors: a high potential return and favorable tax treatment. To successfully manage wealth through generations we have to deal population explosion and taxes. If my three children each have three children, they will collectively have many more mouths to feed than I have. We all know about taxes and the fact that many of the largest investors in the marketplace (pension funds) don't pay them. Family investors are taxed on interest, dividends and gains then taxed again on the same assets at death. The simple lesson is that family investors need to achieve a much higher return than pension funds if they are to successfully pass wealth through generations. The 5% PE return premium can make a real difference. The fact that PE returns will be largely long-term capital gains means a lower tax rate. Moreover, the illiquidity of a PE investment may justify a discount during an estate valuation. For these reasons, family groups should seriously consider maintaining a substantial, ongoing commitment to a diversified private equity program.