Pittsburgh (Reuters) - Publicly traded private equity? It sounds like an oxymoron - like jumbo shrimp or corporate responsibility.
But what was once the exclusive domain of wealthy investors can now be explored by everyone. Worldwide, there are about 200 public companies listed on exchanges that invest in private equity. A handful of U.S. mutual funds and ETFs also do so.
Are these “listed” companies worth buying? Yes, but with some caveats.
Listed private equity has some key differences from an unlisted investment. One key advantage of listed private equity - it can be bought and sold any time you please. By contrast, investors’ capital in unlisted private equity funds can be locked up for several years. Distributions may be made only as investments are converted to cash, with limited partners having no right to demand that sales be made.
Liquidity can have its disadvantages too. Because they are publicly traded, shares of a private equity company like American Capital sometimes perform differently from those of the underlying portfolio of private businesses.
Despite the potential for volatile short-term fluctuations, the long-term returns of listed private equity shares mirror those of unlisted firms. Listed funds’ portfolio returns have a 94 percent correlation to that of unlisted over the last decade, meaning that their returns are similar 94 percent of the time, according to Prequin, an alternative asset research firm.
When listed private equity trades at a discount, you have a chance to get in on a private equity investment on the cheap. Currently, the average listed private equity company trades at a discount upward of 15 percent. So you’re getting at least a dollar of private businesses for every 85 cents you invest.
For retail investors, there are currently two listed private-equity ETFs — PowerShares Global Listed Private Equity and ProShares Global Listed Private Equity. In addition, investors can choose from two mutual funds — ALPS Red Rocks Listed Private Equity and Vista Listed Private Equity Plus. All four invest in a diverse basket of listed private equity companies, like American Capital.
The differences in performance between these products highlight the sector’s complexity. Both mutual funds were crushed in the 2008 crash, each falling by more than 60 percent, as the private equity sector, in general, suffered from over- leveraged buy-outs.
In the surge that’s followed, Vista’s fund has dramatically underperformed, producing only a 9.9 percent annualized return in the last five years through April 22, less than half ALPS’ 24.8 percent. The expense ratio for the Vista fund is 2.24 percent of assets and 1.51 percent for the ALP’s fund.
One reason for ALPS’ outperformance is that it largely avoids what is known as business development companies, or BDCs. These invest primarily in the debt of private companies and pay shareholders the income generated. While BDCs have performed well in the recovery, paying double-digit yields, other companies in the sector have done much better.
“BDCs are not private equity,” says Mark Sunderhuse, ALPS’ co-manager. “They’re yield investments and their returns are much more correlated with high-yield bonds.” Although Sunderhuse will occasionally buy BDCs when they trade at deep discounts for his actively managed fund, he largely avoids them because he sees them as over-valued.
By contrast, Vista’s fund has a 20 percent weighting in BDCs like Fifth Street Finance and BlackRock Kelso Capital.
“BDCs are an important part of the asset class,” says Vista co-manager Luke Aucoin. “They still provide much-needed capital to private companies.”
In ALPS Red Rocks’ top 10 holdings are private equity managers Blackstone, KKR and Apollo Global Management. Although these are some of the most famous private-equity managers in the world, when you buy their stocks you are investing in the money managers themselves, not directly in their underlying private equity funds.
Investing in Blackstone or KKR would be like buying shares of Fidelity or Vanguard if they traded on the stock exchange instead of their underlying mutual funds. In addition, the management fees for running the funds also determine the performance of the stocks.
“We only want to have exposure to private equity deals, not the management fees for the funds,” says Michel Degosciou, managing director of LPX Group, a firm that tracks listed private equity and created the index the ProShares ETF tracks.
For the purest private equity plays, investors have to look overseas. Two-thirds of Sunderhuse’s portfolio is outside of the United States - companies like Onex in Canada, Eurazeo in France and Ackermans & Van Haaren in Belgium. They have matched the sector’s stunning performance of late while owning private-equity directly, just like traditional private equity funds. They also trade at double-digit discounts to net asset value.
Despite the strong returns in recent years, the outlook for the sector remains good. The merger and buyout deals private equity companies are financing are much more conservative than in the heady days prior to the 2008 crash. The amount of debt used to finance the deals is about half what it was in 2007, says Sunderhuse.
With interest rates so low, even that safer level of leverage is easier to manage. So for those who can stomach the volatility, now might be the time for oxymorons.
(The author is a Reuters contributor. The opinions expressed are his own.)
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Editing by Lauren Young and Dan Grebler)
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