What Investors Get Wrong About Publicly Traded Private Equity Firms

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. Disclaimer: Any mention of individual, publicly traded stocks is only meant as an illustrative example. Any mention of a stock should not be construed as investment advice (Anlageberatung or Anlagevermittlung).

Private equity is a common topic on this newsletter. While my content is typically aimed at affluent investors, who can invest in private equity funds directly (i.e. 200K€ per fund or more), I know that many of my readers are not (yet) in those spheres, but nonetheless interested in the topic. The frequent questions that I receive around ‘democratized’ access to private equity through feeder funds or ELTIFs was the motivation for my recent newsletter Private Equity for the Masses.

But regardless whether its an affluent investor, a mid-career professional or a student, there is one question that frequently comes up:

Why should I invest in a non-traded private equity fund if I can’t just invest in publicly traded private equity firms - such as KKR, Blackstone or Apollo?

And it’s a valid question. Besides the question of access, the motivation to look at public alternatives stems from private equity’s typical challenges around illiquidity, which arises from the fact that private equity funds are typically not traded (i.e. entirely illiquid) or at best semi-liquid - which in return is a topic that both regular and highly affluent investors care about. But in picking public proxies for private equity, we need to be careful that we find an investment that actually provides us with the intended access to the asset class. 

So today, let’s talk about publicly traded private equity firms, and why they might not be the investment you are looking for. But before we tackle that question, we need to go back to the basics.

Private Equity 101

A private equity fund structure typically looks something like this:

Let me explain:

The fund is the entity into which you as the Limited Partner invest. Funds are typically structured as a so-called Partnership (in Germany, it would be a Kommanditgesellschaft, i.e. a KG or a GmbH & Co. KG), with its shareholders being split into Limited Partners and General Partners (more on that below). The fund is typically a closed-end fund, meaning that it is set up for a defined period with defined shareholders and it is liquidated only at the end of the fund’s life, but could also be an open-ended structure without a defined term (i.e. being able to recycle capital from exits) from which investors can redeem their shares along the way. The capital of the fund is what is invested into its portfolio companies, and is returned through dividends, interest payments, and/or an eventual sale of the portfolio companies.

The fund is managed by the General Partner (often abbreviated to “GP”). The GP is the private equity firm, which takes over the management of the fund, for which it receives an ongoing management fee as well as a performance-based fee (“carry”) when investments are realized. It is typically also a small investor in the fund itself. (Practically the structuring is a bit more complex with separate entities for GP, management, and the carry, but we won’t go into detail here for the sake of simplicity.) Most importantly, the General Partner is theoretically liable for any liabilities of the fund if they exceed the capital provided by limited partners.

This is different to the Limited Partners - the investors. They provide most of the fund’s investable capital. They indirectly pay the management fee to the GP, but in return are first in line to receive their invested capital back, plus a so-called preferred return. Beyond the return of capital and the preferred return, they split incremental returns with the GP (i.e. if there is a 20% carry, incremental returns would be split 80/20 between LP and GP). And as the name says, they are Limited Partners, meaning their liability is limited to their commitment to the fund.

So let’s see how this would work in practice, step-by-step, with the fictional example of a fund that invests in a single company:

• The Limited Partners (and to a small part, the GP) commit capital to the fund.

• The fund’s capital is mostly invested into the single company. A part of the fund’s capital is paid to the GP for their service of managing the fund - the Management Fee.

• The GP manages the acquisiton, growth and eventual exit of the portfolio company. For this service, they receive the ongoing Management Fee.

• Once the company is sold, the LPs first receive their money back. They receive the invested capital and the preferred return. Once that point is reached, incremental capital is split between the LP and the GP’s performance fee.

• Once the portfolio company is sold, the fund is liquidated.

So if we want access to private equity in the traditional sense, our publicly traded investment should be an investment in the fund, meaning a diversified portfolio of non-traded businesses. Do our publicly traded options live up to this expectation? Let’s find out.

Investing in PE GPs: Not quite the right exposure

After our little explanation, you might already have a suspicion: That investing in GPs - i.e. the stock of Blackstone, KKR, or other publicly traded PE firms, might not be the ‘pure’ private equity exposure that we are looking for.

Let’s look at our aforementioned example again, but this time, let’s use numbers:

• The LP invests 95€ into the fund, which is scheduled to run for 5 years.

• The GP invests 5€ as their GP commitment, which we assume is subject to the same fees as the LP (typically not the case).

• The GP gets paid a 2% management fee, and a 20% carry on any gains. (For sake of simplicity, we assume no preferred return.)

• The GP invests the maximum amount minus the capital required for the management fee into the company, i.e. 90€.

• The company is later sold for 180€, i.e. a 2x multiple.

If you are the LP, your cashflows and return profile would look as follows:

• You invest 95€ into the fund.

• You pay 95€ 2% 5 years = 9.50€ in management fees over the course of the investment, meaning that 84.50€ was invested in the company.

• The company is sold for 180€. You first get your 95€ investment back (part of which was spent on the management fee), as does the GP with 5€.

• The additional 80€ is then split with the GP in a 80/20 ratio, i.e. the GP receives 80€ 20% = 16€ in carry, you receive 64€ 95% (your share of the fund) = 60.80€. The GP gets the remainder, i.e. 3.20€.

• In total, you invested 95€ and receive 95€+60.80€ =155.80€ back, for a total net multiple of 1.64x.
  

• As the GP, things look a bit different:

• You invest 5€ into the fund. As outlined above, you get back your 5€ + 3.20€ after carry, i.e. 8.20€ for the same 1,64x net multiple on your GP commitment.

• In addition, you receive the 10€ in management fee (which you might have to spend on your team and operational costs). Let’s assume that after expenses at the GP level, there’s no profit from the management fee cashflow.

• Lastly, you get 16€ in carry.

• In total, you invested 5€, but you got back 5€ (invested capital) + 3.20€ (profits after fees) + 16€ (carry) = 24.20€, for a multiple of 4,84x (!).

Your might wonder - is this not a much better deal? In theory, yes. In practice, slightly more challenging, especially when we try to invest in GPs that are publicly traded:

• Publicly traded GPs are typically not a pure play. The very large players (Blackstone, KKR, Apollo) have long moved on from just private equity, offering its investors access to other alternative asset classes such as private credit or infrastructure. There’s also a continued push of alternative investment firms to turn themselves into insurance companies to provide them with even longer-duration, if not permanent capital. In other words: It’s tough to buy into a GP providing you with the specific exposure you’d receive from a single fund.
   

• You don’t buy into the GP ‘at cost’. Let’s assume you find a publicly traded GP that has stayed true to their roots and invests in just one specific asset class, like private equity. But no matter if private or public, if they are a successful, established GP, you can’t just give them a dollar so that they invest it into the aforementioned situation: As with any successful company, you’d likely pay a valuation of a double-digit multiple of their fee-related and performance-based earnings, and maybe even a premium to the book value of their GP commitments. If you invest a fund, you at least invest ‘at cost’ for the individual investments.
  

• Your earnings are more volatile. If you invest a dollar into a private equity fund, you have no guarantee of good returns - but you are always first in line to receive money back. If you are a GP, things are more volatile. Going back to the aforementioned example, most fee-related earnings might go to paying the team and organization, meaning that your outsized gains are dependent on carry. But especially in this day and age, carry-related earnings are hard to come by, both due to challenges in economic situation (tariffs, inflation, higher interest rates) and exit environment (less activity, meaning the hurdle rate runs against you). With carry being delayed or not coming at all, your GP investment might be much less lucrative.

To be clear: Alternative asset management firms have a fantastic business model. Management fees for established GPs are typically higher than ongoing costs for team and organization. Given that funds are typically set up for 10 years or even essentially permanent, shareholders of such businesses can expect extremely reliable long-term cash flows - which is why publicly traded GPs focus much more on fee-related, recurring earnings than potentially much higher but volatile performance-related fees in their investor communications. It also explains the continued rise of so-called GP Stakes Investing (pioneered by my alma mater Goldman Sachs with their Petershill funds), in which specialized funds acquire minority stakes in non-traded alternative asset managers.

As more investors recognize the attractiveness of this business model, the valuation of publicly traded GPs continues to grow, and those higher valuations require them to gather more and more assets to fulfill investor expectations. Maybe the continued democratization of alternative investments will drive more assets flows, and thus, higher fee-related earnings for those firms. Or maybe it won’t - and amid a challenging exit environment and lower returns for alternatives, might lead to a repricing in those publicly traded GPs. Which is all fair, and a reality of the risk-reward of publicly traded stocks. But if you are not looking to buy into that risk-reward, but are just looking to get publicly traded access to private equity or other alternative asset classes, shares in traded GPs might simply not be the right investment for that.

So with that in mind, you might come to the conclusion that buying into a publicly traded GP is indeed not be the right way for you to gain private equity exposure. But you might still wonder: Are there any publicly traded options (and not just a backtested but practically unproven replication strategy) that do work? I think so - in the form of structures with creative names such as Investment Companies, Investments Trusts and Traded Closed-End Funds (CEFs). 

But more on those in a future article.

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