Private Equity for the Masses

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive!

Despite its recent challenges, private equity continues to be very en vogue these days. But while institutional investors and many affluent investors have invested in private equity for years, if not decades, the ‘mass affluent’ with net worths ranging from 100.000 to 500.000€ are only now starting to receive access the asset class. You can thank the so-called democratization of finance, which allows individuals to invest into the asset class from amounts as little as 10.000€.

While this range of net worth and typically low complexity is perhaps at the lower end of where we at Cape May can really shine, it is a range where many of our friends, supporters and newsletter readers find themselves in. As a result, we are often asked whether private equity is something the typical mass affluent investor should be looking at - and if so, what the best ways are to access that asset class.

So for today, let’s move away from the world of ultra-high net worth individuals and family offices. Let’s think about how the figurative ‘Average Joe’ should think about private equity. But even if you count yourself in the lucky group of wealthy individuals - I promise, you might learn something as well.

The Basics

Before we dive into the question of accessing private equity, let’s first cover a few basics that investors, affluent or not, should be familiar with.

Private equity typically invests in the equity of established businesses with the purpose of later selling that equity at a higher price. They are typically majority owners of those companies, manage or might even replace the management team, and are heavily involved in the day-to-day strategy of said business.

Along the way, there are many ways how private equity can make money. First of all, they typically make heavy use of leverage (hence the ‘leveraged buyout’) - one, to fund the acquisition itself in order to not have to pay the full purchase price in equity, and two, for growth and/or additional acquisitions of related businesses along the way. (Sometimes, they even take on debt to accelerate distributions to their owners through dividends, a so-called ‘dividend recap’). However, debt isn’t a return driver, it just enhanced the return in either direction - return drivers that increase the value of the business are top line growth, margin expansions, and so-called multiple expansion (i.e. selling the business at a higher multiple of profits than the multiple at time of acquisition). 

To give a very simplified example (experienced readers, feel free to skip):

Cape May Private Equity (CMPE) is looking to acquire SuperTech Inc., a provider of software solutions. SuperTech generates revenues of 5M€ and EBITDA (earnings before interest, taxes, depreciation and appreciation - PE’s favorite metric of profitability sd as it excludes the impact of the company’s capital structure) of 1M€. The founders of SuperTech are looking to sell the company for 5M€, i.e. a 5x EBITDA multiple. CMPE is funding this acquisition with 3M€ of equity and 2M€ of debt.

CMPE manages to grow the company from 5M€ to 6M€ in revenue. Since it’s software, we (unrealistically) assume no incremental costs of said revenue, meaning that this 1M€ increase in revenue directly benefits our EBITDA, which grows to 2M€. (Moving from 5M€ revenue / 1M€ in EBITDA to 6M€ in revenue / 2M€ in EBITDA shows so-called margin expansion from 20% to 33%.)

CMPE then sells SuperTech at a multiple of 6x (multiple expansion!) for 6 x 2M€ = 12M€. They have to pay off the 2M€ in debt, leaving them with 10M€ in proceeds on their 3M€ initial equity investment. A considerable multiple on invested capital of 3,3x.

Of course, this example is very simplified. The use of debt, also called ‘financial engineering’, is no longer the low-hanging fruit of the early days of private equity, back then driving returns as high as 200x.  Growing a company while also increasing its margins is also much harder in practice. But it shows you the clear example of the impact of the aforementioned return drivers of top line growth - margin expansion, and multiple expansion - in action, whose impact can be further enhanced by leverage if things go well.

Risk and Return Expectations

Those are some of details of how private equity works fundamentally. But how should you think about private equity in the portfolio context? What returns should you expect, and at what risk?

In the end, the key term is in the name - it’s still equity. We would expect private equity to perform similar to its public equity counterpart, both in terms of return and risk. Private equity is by nature an actively managed strategy (the closest thing you can get to an ETF is a well-diversified fund of funds), meaning that any investor takes the risk of out- or underperforming a comparable public equity benchmark. Assuming that you pick well-performing managers, we’d expect a private equity portfolio to generate incremental returns of 2-4% p.a. over the comparable, public benchmark and an appropriately long timeframe (8-10 years). While a bit anecdotal in nature, that figure isn’t just made up - it is  backed by historical data, as Markus and I outlined in our Quantitative Approach to Private Equity series (Part 1 and Part 2). If private equity will continue to perform that way, only time will tell.

And from that series, we can also draw insights into the question of risk. Unlike what some managers or salespeople in the private equity space say, private equity is not less risky than it’s counterpart. After all, as we explained earlier, private equity investments are almost always heavily levered, which comes with a lower, not higher, degree of volatility and risk:

Sources: Moonfare, Bloomberg, MSCI, Cambridge Associates, KKR, AQR, Kenneth French Data Library, Harvard Business School, Cape May Wealth, Excentrica. As of 12/03/2024. * Moonfare notes: “From 1Q86 to 4Q20 where data is available, deemphasizing 2008 and 2009 returns at one-third the weight due to the extreme volatility and wide range of performance, which skewed results. Using MSCI AC World Gross USD for Listed Equities; Barclays Global Agg Total Return Index Unhedged USD for Fixed Income; Cambridge Associates Global Private Equity for Private Equity; HFRI Fund Weighted Composite Index for Hedge Funds; and Barclays US T-Bills 3-6 Months Unhedged USD for Cash.” For educational purposes only.

So let’s go back to our question of how an investor - affluent or not - should see private equity: To us, it is simply an equity investment with higher risk, but also higher return potential. If you are able to take the additional risk, and are dependent on (or simply want to!) achieve higher returns than what equities have historically offered, private equity can, in theory, be the right asset class for you.

But now, we get back to our initial question: How can I invest in private equity without a seven-figure net worth?

Things To Look Out for

Most mass affluent investors will likely access private equity in conventional ways, i.e. fund investments, feeder funds and/or a fund of funds. Thanks to the aforementioned democratization of finance, platforms such as Moonfare or Liqid provide investors with access from amounts as little as 10.000€. But just because you can access through such means doesn’t necessarily mean you should. What should you look out for?

First, the question of fees.

The question of fees might be somewhat counterintuitive, as private equity tends to be an expensive asset class to begin with. Most managers charge a management fee of 1,5 to 2,0% of the committed amount per year, as well as a performance-based fee (‘carry’) of 20-25% of the gains they’ve generated on the invested capital. If things go well, those fees more than justify the high returns in the aforementioned 10-12% range (i.e. 8% long-term equity return expectation + 2-4%, net of fees, i.e. taking into account those high figures). 

But in the the case of ‘retail’ products, fees can be prohibitively expensive. Often, they charge a one-off fee between 1,0% and 5,0% of the desired investment amount. They might also charge another ongoing management or feeder fee that can range anywhere between 0,25% and 1,00% per year. And lastly, in some cases, they might also charge a performance-based fee. It’s worth noting that these fees all come on top of the already high fee load of the manager themselves.

Assuming we are on the high end of those fees (as might likely be the case for a 10,000€ investment), a 10-year fund investment would see an additional fee load of 0,5% (5,0% upfront fee / 10 years) + 1,00% (management / feeder fee) = 1,5% per year. And if we deduct this from our 2-4% margin of (expected) outperformance, we’re left with ‘just’ 0,5% to 2,5% in incremental performance per year - if things go well, which there’s no guarantee for. Is that enough? That’s for you to decide - even in the space of ultra-high net worth individuals, the opinions can vary.

Second, the question of manager selection.

Yes, they are private equity managers who’ve generated returns of 10%, 15%, or even 20% per year over long timeframes. But those are likely not the managers available to you. Given those track records, they’ll likely have more investor money lined up than they actually want to take, and can pick their investors as they please - which will likely lean towards those that can write large tickets into their fund.

But that doesn’t mean that the flipside is true, either. When I recently reviewed a fund of funds launched by a digital wealth advisor, I was positively surprised by the quality of the portfolio. In prior family office roles, I’ve also invested in managers that ended up raising capital from investors through such democratized platforms as well. In my experience, managers available on those platforms tend to be larger, more established managers who don’t aim for home runs, but stable and predictable returns. Certainly not a bad thing - but in light of what we said about fees, something to take into account.

Third and last, the question of structure. 

I already mentioned the three common structures - feeder fund, fund of funds, and evergreen funds. All of those have important considerations:

Feeder funds give you direct access to an individual fund. If that fund does better than the aforementioned return target, you benefit as well - but of course, the opposite might also take place. It’s also worth noting that any potential performance fee is charged just on that individual manager. In our view, such feeder funds can give the illusion of control, but many investors might be better off with a fund of funds.

A fund of funds partially solves that challenge. Any FoF-level performance fee is typically payable on the level of the fund, not the underlying managers (which might however charge an individual performance fee). So if you have some losers and some winners, the winners first have to offset the losers before the FoF manager receives carry. We like fund of funds because of their diversification (especially if you are a small investor), but be mindful that diversification moves your performance closer to the average, which as we outlined might become less attractive after fees.

Lastly, evergreen funds. Instead of having to invest into funds on an ongoing basis, you can invest once (as you would with an ETF or equity fund), and stay invested until you decide to redeem your shares. Their structure might vary, resembling either a fund of funds or a more diversified private equity fund. Ongoing fees should be comparable to a fund of funds, but performance fees can be on the higher side due to a different calculation method. (For more insights into the ‘permanent capital’ trend, which also includes the growth of evergreen funds, I recommend our series The Rise of Permanent Capital - see Part 1, Part 2, and Part 3.)

There’s also a few more things to look out for, that I won’t go into more detail but still wanted to mention: One, that private equity is a very long-term investment (think 7-8 years until you get just your investment back, and perhaps 10-12 years until a fund is fully liquidated). Two, that the asset class can be quite complex from a tax angle - specially US-based investments might bring complexities and disadvantageous tax rates compared to a simple ETF investment.

The Verdict

So taking all of these factors into account: Is it worth for mass affluent investors to invest in private equity? As of today, I have to admit that I am sceptical. 

Interestingly, it’s not for the fee load. If they are not at the upper end of the aforementioned ranges, a well-structured investment can absolutely make up for them (although investors should always be mindful of any type of fees). So why then not invest in private equity? To me, in the case of our affluent investors, it’s a question of return on invested time.

Assume you are a mid-career professional who has built an investment portfolio of 500.000€. Until now, that portfolio is invested in diversified, liquid assets generating a return of 8% p.a. You’re now contemplating investing 100.000€ of that portfolio into a fund of funds (leaving aside the discussion if that’s the right amount or not) that you are able to assess through one of these aforementioned platforms at a somewhat fair price - no upfront fee, 1% management fee, no carry. 

Is it worth it? From the return perspective, the argument can certainly be made. Let’s generously assume that our well-constructed fund of funds generates an outperformance over equities of 3% p.a. before costs, i.e. roughly 2% p.a. after fees (also taking into account the IRR-return-difference, as outlined here). Over a 10-year timeframe, our diversified portfolio would compound to 216.000€, while our fund would compound to roughly 259.000€ - a substantial 43.000€ difference, or 4.300€ per year.

But what if we take other factors into account? One underestimated point is the time investment. From my experience, fund investments have some administrative efforts, requiring you to take care of capital calls, tax forms, and repeated KYC checks. All doable, but they take up time. The tax matter might even have some financial impact of an hour or two of work for your tax advisor. Depending on what your (theoretical) ‘hourly rate’ is, the additional work might quickly eat into the excess return over a simple investment.

But there’s another point, also to be taken in context of your time investment - and that’s your expected income and wealth progression. If you’ve managed to build 500.000€ through nifty investments, savings, or maybe some entrepreneurial activity (like a secondary), there’s a good chance that you won’t stop there. Especially as individuals come into their highest-earning years, wealth and earnings start compound substantially. If you invest in a low-cost index fund, all is well - you can always invest more money for the associated work to be worth your time. But with a PE fund, your allocation is locked in, so if your wealth grows considerably in the near future, the 4.300€ per year might all of a sudden not be worth it anymore for the associated work. Or it might even go the other way, with the investment losing money, yet still taking up a notable amount of time.

Admittedly, things might get a bit easier in the future, as more high-quality evergreen funds come to market at lower minimum investment amounts. If structured right, they should be as straightforward as an actively managed fund, the only difference being how often you can sell them (i.e. monthly, quarterly instead of daily). But that is still a young market - and you should thread carefully.

So if you fall into the ‘mass affluent’ category, think hard about whether you want to spend time and money on private equity. If you are willing to take the risk, by all means, go for it. But in our experience, there are better ways to spend your money and time at that level of wealth, such as entrepreneurial matters like a bit of consulting on the side, or simply some additional focus on your day job.

Liked what you read? If you enjoyed this piece, make sure to subscribe by adding your email below. I write about topics covering the world of family offices, asset allocation, and alternative investments.