Credit: Shutterstock photoAh, memories. Remember when endowment-style investment was all the rage? You know, before the market meltdown of 2008-2009? Those were the days when investors clamored for portfolios that looked like those managed for the benefit of Harvard and Yale universities. Yale's chief investment officer, David Swensen, in particular, was elevated to guru status by alums and envious investors for his two-decade streak of stock market outperformance. (We examined Swensen's style in our July 2007 article, "Illiquidity Is Beautiful For Some.")
Yale and the other Ivies, of course, weren't entirely insulated from last decade's market swoon. Correlations spiked across most all asset classes, so even broadly diversified portfolios like the endowments took big hits. Thankfully, the bespattering of Yale Blue and Harvard Crimson was quickly mopped up. The dramatic post-crash rebound in the Yale portfolio's value, in particular, was largely due to a growing commitment to private equity.
At 33 percent, private equity is now Yale's largest asset allocation. The Elis have built up their commitment by ratcheting up exposure in stair steps from the 17 percent level in 2006. Private equity took primacy mostly at the expense of the endowment's hard asset investments. (The comparably nimble Harvard endowment has kept its target allocation to private equity steady at 13 percent over the past few years.) The Yale and Harvard private equity investments are outsized compared with those of other educational institutions which average a 10 percent allocation to the asset class.
The universities' private equity investments consist of participations in venture capital and leveraged buyout limited partnerships. Yale, for its part, has big expectations for its managers, which include venture capitalists Greylock Partners, Kleiner Perkins Caufield & Byers, and Sutter Hill Ventures, as well as buyout specialists Bain Capital, Berkshire Partners, Clayton Dubilier & Rice, and Golden Gate Capital. The aggregate real return generated by the partnerships is targeted at 10.5 percent with a 27.7 percent risk (annualized standard deviation).
Such high falutin' returns come with an equally heady buy-in. There's a six-figure threshold for partnership interests, certainly doable for a $19.4 billion portfolio like Yale's, but clearly out of the reach of everyday investors. That doesn't mean that Main Streeters are necessarily foreclosed from private equity, though.
Publicly Traded Private Equity Firms
There are a handful of private equity firms that are - paradoxically - publicly traded. Could some of private equity's recent good fortune have trickled down the balance sheet to the benefit of small shareholders?
Most of these entities are organized as business development companies (BDCs). BDCs raise money through equity and debt issuance, much like merchant banks, to fund loans to medium-sized private companies. A BDC's objectives are income generation and capital appreciation though, as we shall see, these objectives aren't often realized. Essentially, a BDC offers investors an opportunity to buy many businesses with a single purchase.
BDCs are required to pay out 90 percent of their earnings as dividends which are taxed as ordinary income for shareholders. This makes BDCs particularly attractive for dividend-hungry tax-deferred accounts. Ideally, BDCs should combine high yields with relatively low leverage.
Volatile Investments
BDCs are very volatile investments. Their stock performance, like that of their pass-through partnerships, suffered mightily in the 2008 market slump.
In the general sell-off, the private equity market faced a killer combo wrought by the implementation of Financial Accounting Standard 157 and skepticism of the underlying companies' values. As a result, many BDC net asset values were sent to the canvas.
Dividends headed south or, in many instances, were eliminated entirely. Some companies attempted to salvage their balance sheets through equity issuance, to differing effect. Those with track records that could justify a premium over book value offered accretion to existing shareholders, while others merely diluted investors' interests. The differential effect on share values was dramatic.
A BDC's debt-equity mix largely determined its post-crash performance. The heavier the debt weighting, the more the investment acted like a leveraged bond fund. With that in mind, investors and advisors are wise to use a BDC's total annual expense ratio as a measuring stick.
A BDC's investment mix also determines its potential return. The return on a debt-weighted portfolio is essentially capped at the interest rate and doesn't offer upside exposure to portfolio companies' operations. The formula for big gains in an anticipated economic rebound is equity participation.
So, what choices do investors have? Six publicly traded investment firms and an exchange-traded fund (see Table 2) stand out as exemplars of private equity performance over the past five years.
Ares Capital Corporation (Nasdaq: ARCC) - Ares Capital is the only one of our baker's half-dozen that has managed to post a five-year gain in its share price. (See Chart 1 and Table 2.) That's not to say that ARCC has always stayed above water, though. The stock, now at $16 a share, was perilously close to $2 in the spring of 2009. Still, ARCC's 53 percent standard deviation makes it the least volatile of the business development companies.
A key contributor to Ares Capital's upside is its modest leverage. Its debt-to-equity ratio is less than 1. At 11x earnings and a price-to-book ratio around 1, ARCC is a fairly low-priced stock as well. Ares Capital has pulled off earnings surprises for the past two quarters, exceeding consensus estimates by 20 percent on average.
The median one-year price target for ARCC is $17.30, according to Thomson/First Call. Given the stock's current price, its upside seems modest at best, but is complemented by a forward dividend rate of 9.1 percent. Ares Capital's dividends have been the highest and most consistent of all the BDCs.
And the Winner Is…
All told, Ares Capital stands head and shoulders above the other BDCs, though its stock might be close to being priced to perfection. Keeping in mind the illiquidity of the underlying portfolio, ARCC may be a fairly reliable high-yield alternative to junk bond funds for risk-tolerant accounts.
Speaking of funds, there's an exchange-traded fund that tracks the private equity market. The PowerShares Global Listed Private Equity Portfolio (NYSE Arca: [[PSP]]) is based on an index of three to five dozen listed private equity companies, including business development companies and other financial institutions.
The ETF's diversified portfolio certainly dampens its price volatility but, so far, has offered less than middling returns.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
