02/10/2024
Private equity exposures available through wealth management channels are likely to underperform their comparable institutional benchmark.
Here’s why.
Individual investors represent the largest portion of investable wealth in the U.S. but remain substantially under-allocated to private markets at (20%).
As a result, many large-scale ‘alts’ players are keen to diversify their LP base by raising capital from individual investors.
It is generally neither economical nor practical for these players to distribute their products directly to individual investors (for reasons related to their scale, existing LP base, cost structure, etc.).
As such, these firms typically turn to distribution agreements with intermediaries where demand is aggregated with preexisting critical scale (e.g., RIAs, IBDs, private banks, etc.). These 'gatekeepers' are the operational backbone for client-facing financial advisors (FAs).
While gatekeepers do, of course, create value through access—there are hidden costs that arise from their scale and embedded incentive structure.
Traditional PE funds are characterized by certain structural features:
Drawdown vehicles = minimize cash drag
Illiquid = execute value creation cycle
Finite life = return capital to LPs
These are features, not bugs, and exist to enable GPs to execute their strategy and, ostensibly, maximize performance for their LPs.
The problem, though, is that gatekeepers often have a borderline allergic reaction to each.
Drawdown structure = operational complexity
Illiquid = client risk
Finite life = less profitable
Enter, tender/interval funds—an increasingly popular vehicle through which individual investors are supposedly accessing PE exposures via these gatekeepers.
Tender funds are essentially mutual funds but with 'alts' as the underlying rather than stocks/bonds.
Gatekeepers generally have a strong bias towards tender funds, they’re scalable, evergreen, single-call, and have intermittent liquidity (usually quarterly). Put otherwise, they afford greater profitability and operational simplicity relative to traditional PE.
Incentives drive outcomes. And here, they’re misaligned.
Wrapping a traditional PE fund in a tender fund vehicle can result in structural trade-offs that tend to have the net effect of diluting performance:
Single-call = increases cash drag
Liquidity = requires credit allocation to manage redemptions
Leverage = constricts investment strategy
What does this all mean?
PE exposures wrapped in a tender fund structure take a different form—the investment and portfolio strategy must be necessarily different, and many of these changes are more likely than not to result in performance dilution (see chart).
The combination of structural dilution and fee layering ultimately creates a highly profitable investment product for gatekeepers but one that is almost certain to underperform the applicable benchmark for end investors.
