How to Invest in Publicly Listed Private Equity

We are going to ignore the options available to those people with $50 million who probably have their own family office and have a staff to help select funds. There are certainly a number of private equity

Table 5.3 Yale Private Equity Returns 1988-2006

Venture

Capital Buyout International Total

Venture

Capital Buyout International Total

Table 5.3 Yale Private Equity Returns 1988-2006

1988

-0.70%

7.80%

-0.02%%

3.30%

1989

-0.30

38.70

13.40

23.40

1990

15.60

7.30

-4.40

11.80

1991

11.60

14.70

-10.00

6.10

1992

28.30

7.20

4.10

14.60

1993

13.60

57.30

-0.20

32.30

1994

20.20

18.70

24.00

24.60

1995

37.80

26.30

13.10

27.00

1996

124.80

31.50

33.70

60.20

1997

37.60

22.10

90.20

36.20

1998

38.00

39.80

1.90

29.00

1999

131.40

8.50

- 15.40

37.80

2000

701.00

35.10

38.30

168.50

2001

9.00

-14.70

-3.90

- 5.40

2002

-39.90

-11.20

-0.70

-23.30

2003

-13.20

-0.30

1.30

-4.30

2004

-0.70

32.00

21.80

20.60

2005

25.00

32.40

19.00

28.70

2006

16.70

35.90

46.20

32.20

Annualized Return

32.19%

19.05%

12.15%%

23.34%

Volatility

160.34%

18.72%

24.86%%

39.00%

Sharpe (4.5%)

0.17

0.78

0.31

0.48

Source: "Yale Investment Office: August 2006" by Josh Lerner. Harvard Business School Publishing, January 2007.

Source: "Yale Investment Office: August 2006" by Josh Lerner. Harvard Business School Publishing, January 2007.

fund of funds (FOFs) that could be good options, but we are not in a place to make any recommendations. So what about the little guy?

Private Equity ETFs

There have been some private equity ETFs and a private equity mutual fund that have launched recently. The idea of a U.S.-listed fund is not that interesting because it mainly invests in public companies that are involved in private equity, not the actual funds themselves. A potentially more appealing product became available when PowerShares launched its second private equity ETF to focus on the actual foreign listed private equity funds. (If this seems confusing, consider the difference between Fidelity, the management company, and one of Fidelity 's actual funds, like Magellan—ticker symbol FMAGX.)

Both ETFs include more than 30 publicly listed companies with direct investments in more than 1,000 private businesses. The indexes are rebalanced and reconstituted quarterly and fund holdings are disclosed every day, giving investors a much higher level of transparency than is often available in traditional private equity funds. Hypothetical index returns are available since 1995, but real-time trading in PowerShares Listed Private Equity (PSP) and PowerShares International Listed Private Equity (PFP) didn't begin until 2006 and 2007, respectively. Unfortunately their launch may have coincided with the top in the private equity market; in 2008 the ETFs are down substantially from their highs.

Some of the benefits of the ETFs are that they are accessible to all investors (no minimums), easily tradable, liquid, marked-to-market every day, and do not have any lockups. The underlying indexes were designed by Red Rocks Capital. The U.S. ETF is based on the Red Rocks Capital Listed Private Equity Index and the foreign ETF is based on the Red Rocks International Listed Private Equity Index.1

What do the historical (hypothetical) returns look like?

Table 5.4 indicates that the PSP is highly correlated with the NASDAQ as well as the Cambridge venture capital returns. The PFP is also highly correlated to the NASDAQ, but even more correlated to foreign stocks (MSCI EAFE), which makes sense given that most of the holdings are foreign. In both cases the absolute returns of the portfolio increase along with the volatility resulting in only a minor bump in the Sharpe Ratio. It looks like both ETFs will approximate median venture capital and buyout returns, which are going to behave very similarly to U.S. and foreign equities. While we did not include 2008 data since Cambridge Associates has not reported yet, it was a terrible year for private equity. Both listed ETFs were down over 60%.

'You can find more information at www.listedprivateequity.com.

Table 5.4 Private Equity ETFs in a Portfolio

Ivy S&P 500

Table 5.4 Private Equity ETFs in a Portfolio

Ivy S&P 500

1996

19.32%

22.96%

1997

9.96

33.36

1998

0.49

28.58

1999

14.46

21.04

2000

12.73

-9.10

2001

9.74

-11.89

2002

2.09

-22.10

2003

25.70

28.68

2004

17.44

10.88

2005

11.74

4.91

2006

12.07

15.80

2007

8.06

5.50

Annualized Return

9.87%

9.32%

Volatility

9.47%

17.78%

Sharpe (5%)

0.62

0.30

Correlation to S&P 500

0.49

Correlation to EAFE

0.64

0.74

Correlation to NASDAQ

0.42

0.81

Correlation toVC

0.27

0.38

Correlation to Buyout

0.70

0.80

EAFE

NASDAQ Composite

Venture Capital

Buyout

PSP

PFP

6.36%

22.71%

40.64%

28.66%

15.45%

27.91%

2.06

21.61

37.66

29.27

48.68

-0.17

20.33

39.63

26.87

15.05

16.20

29.70

27.3

85.59

275.48

35.36

120.83

82.74

-13.96

-39.29

29.1

2.01

2.70

-1.26

-21.21

-21.05

-39.00

-11.04

-3.09

-14.45

-15.66

-31.53

-31.80

-7.56

-14.09

-9.76

39.17

50.01

-2.21

23.37

71.48

67.24

20.70

8.59

15.40

24.37

25.76

37.44

14.02

1.37

8.30

28.02

6.06

30.40

26.86

9.52

17.96

27.06

21.93

29.26

11.57

9.81

16.25

20.39

-13.06

3.67

8.21%

8.01%

19.29%

16.92%

20.24%

20.39%

18.96%

35.12%

80.33%

15.26%

38.97%

29.95%

0.22

0.11

0.19

0.85

0.42

0.55

0.74

0.81

0.38

0.80

0.62

0.61

0.79

0.39

0.79

0.62

0.87

0.79

0.73

0.73

0.85

0.85

0.39

0.73

0.55

0.80

0.67

0.79

0.73

0.55

0.60

0.70

Roger Ibbotson takes a look at the Listed Private Equity (LPE) Index and the International LPE Index and their hypothetical history. Ibbotson created his own data series to compare to Red Rocks backfilled series, and found that their results lagged the LPE Indexes by about 5% a year. Whether this is due to this survivor bias, optimization, or simply different construction methodologies is hard to say. Ibbotson recommends, "Institutional investors with access to top quartile managers should continue to use traditional private equity funds to implement a target private equity allocation. For investors who do not have access to top quartile managers and want to include an allocation to private equity, investing in listed private equity is a viable and exciting alternative that, over time, should more accurately reflect the private equity class." (Idzorek, 2007)

Another problem with the foreign listed private equity ETF is tax consequences. Initial research has indicated that there are likely negative ramifications for holding the PFP in a taxable account (see the foreign listed hedge fund section in the next chapter for a full explanation). The recently listed Lehman Opta Private Equity ETN (ticker PPE) could get around the problem due to its structure as a debt vehicle. However, as evidenced by the implosion at Lehman Brothers, you are still exposed to the creditworthiness of the parent company when investing in an ETN. Hopefully, another company will come along and come out with a competing product that avoids all of these issues.

Before you go considering individual foreign listed private equity funds, you need to understand the risk. Many of these funds use leverage and overcommit their capital—beneficial to returns in up markets but devastating in bear markets.2

For an interesting examination of one of the oldest business development companies in the United States, Allied Capital, read the book Fooling Some of the People All of the Time by hedge fund manager David Einhorn. In the book, Einhorn describes his battle with Allied Capital in which, after his fund shorted the stock, he launched into a vocal public campaign against the company in which he alleged shoddy management and outright fraud.

2Google Private Equity Holdings ticker symbol PEH, for an example.

We feel like it is simple enough to exclude private equity for the individual investor. For those interested in including private equity in the allocation, it should be viewed as a substitute for part of the domestic and foreign equity allocations.

A tactical approach to private equity could make more sense, which we will take up in Chapter 7. For those looking for more information on private equity we suggest you read the Ibbotson paper, "Private Equity and Strategic Asset Allocation," the Vanguard paper "Understanding Alternative Investments: Private Equity Performance Measurement and Its Role in a Portfolio," and the book Private Equity as an Asset Class by Guy Fraser-Sampson.

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Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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