Private equity may be riskier than you think
- Robin Powell
- Oct 7, 2024
- 4 min read
Private equity is no longer just the domain of institutions and ultra-wealthy investors. Increasingly, retail investors are being encouraged to get involved too.
But is that a wise move? In today’s higher interest rate environment, the private equity risk profile may be significantly more troubling than it first appears.
From infrequent valuations to long lock-in periods, there are several layers of risk that aren’t always made clear upfront.
KEY TAKEAWAYS
1. Higher interest rates magnify private equity risk
Private equity firms often load companies with high levels of debt. With rates now higher, these businesses may struggle to service that debt, increasing the risk of default or bankruptcy.
2. Volatility is under-reported
Private equity is often seen as less volatile, but that’s largely due to how infrequently these investments are revalued. Their risk can be just as high or higher than similar publicly traded companies.
3. You may not know how it’s performed for a decade
Returns on private equity typically take ten or more years to become clear. That makes accountability difficult and increases the chance of disappointing outcomes, especially if you’re not in a top-performing fund.
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https://www.evidenceinvestor.com/post/how-good-are-institutions-at-selecting-private-equity-managers
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TRANSCRIPT
Robin Powell: Private equity used to be an asset class for institutional and very wealthy private investors.
Increasingly, though, ordinary investors are seeking exposure to it as well.
But how much risk are they taking? Retirement actuary Larry Pollack says private equity is more risky now that we’re no longer in a near-zero-interest-rate environment.
Larry Pollack: Higher interest rates make it more likely that a portfolio company won't be able to service its debt and the portfolio.
So companies tend to have a lot of debt. I mean, part of the playbook is to put, you know, to load these companies up with a fair amount of debt, much more so than you would see in publicly traded companies.
I mean, publicly traded companies have that as well. But you're going to see a lot more of it in these types of companies.
So with higher interest rates, that means they have to pay more interest. That makes them, you know, more difficult for them to service the debt and puts them more at risk of bankruptcy.
RP: A claim that’s often made about private equity is that it’s less volatile than public equity. But, having studied the subject in detail, Larry Pollack says that’s not the case.
LP: The apparent lower volatility and what gets reported as lower volatility is almost certainly an artifact of the fact that these appraisals of these portfolios are very infrequent, so that the fact that you can't see these things move around, you know, in real time makes them appear to be less volatile.
A company that's that private, there's no reason to think that the value is less volatile than a very than an identical company that happens to be public right?
RP: Before making any major investment decision, you need to weigh up the risks and potential returns.
Here are some of the questions to ask yourself about private equity.
LP: Do you believe the claims of higher returns and lower volatility and diversification, despite all the reasons for skepticism? Are you certain that whatever exposures you're seeking can't be realized with publicly traded investments at much lower expense and higher transparency and more liquidity?
Are you certain you could outperform your public pension plan or are you going to ensure you're going to outperform Nevada, which has like a three person investment staff and invests you know, almost exclusively in index funds and has outperformed almost every other public pension fund in the country.
You know, given the difference between top and bottom quartile performers, you know, why do you think you can identify the top quartile future performers instead of the bottom quartile performers?
None of this really should be taken as investment advice, but certainly for myself and based on my research, I wouldn't do it myself and I wouldn't advise anyone else to do it either.
RP: Another consideration is the timescale of investing in private equity. It could be at least another ten years before you really know how well, or otherwise, your investment has performed.
LP: The ultimate success of a fund typically isn't known, you know, for ten or more years after the initial investment. And that ten years is often longer than the future tenure of the people who make the decision to invest in a particular fund. So it's, you know, it's hard to hold people accountable for an investment that turns out badly.
So they can, you know, they can make all kinds of claims when they make the investment. But the way it ultimately turns out that they may be on to something new or we're happy, maybe they've retired or or whatever.
RP: If in doubt, you should always seek professional advice. If necessary, deliberately seek out conflicting advice. Private equity is not an investment you should enter into lightly.
© The Evidence-Based Investor MMXXV
