But the number of public companies has been declining over the years, paving the way for a growing private-company universe (FIGURE 1). In addition, more private companies have delayed going public, creating an opportunity set that’s both large and global in nature. There are more than 200 million private companies in the world¹ compared to roughly 40,000 public companies.²

Risk/Return Profile

One characteristic that makes private-equity investing desirable is the return potential over time. Private-equity investing has yielded higher returns than various public-equity-market segments, and outpaced fixed income since 2001, while also offering compelling risk-adjusted measures of return (FIGURE 2).

The components of increased return potential stem from several factors including an illiquidity/complexity premium, information availability/mispricing, increased operational control, and lack of shareholder influence. 

Within the broad private-equity category and its various sub-categories, dispersion between top-quartile and bottom-quartile managers can be quite wide.

Another important aspect of return potential for private-equity investors is manager selection. Within the broad private-equity category and its various sub-categories, dispersion between top-quartile and bottom-quartile managers can be quite wide (FIGURE 3). Therefore, it’s important that an investor choose a private-equity franchise that has a history of generating value for its investors, coupled with the resources, experience, and network to access the global opportunity set of private companies.

Diversification

Private-equity investing has a relatively low correlation to traditional investments, such as public equity and fixed income (FIGURE 4). Private investments generally have a longer time horizon and a focus on long-term value creation, rather than the quarter-to-quarter focus common in public markets. Since private-equity investments don’t trade on an exchange, valuations tend to experience a smoothing effect as they aren’t marked daily as with public markets. This diversification property may become especially valuable during periods of public-market stress, when investors want to shed risk, which can end up pushing the valuations of public companies lower.

Incorporating Private Equity into an Allocation

Many non-institutional investors have attempted to imitate the allocation framework used by college endowments and large pension plans, but one must consider that these entities have a presumably infinite time horizon and ability to withstand short-term volatility and any potential losses of capital.  While endowments and pension plans have been known to allocate up to 30% of their allocation to private equity, this is likely imprudent for high-net-worth investors who may have a finite time horizon, differing risk tolerances, and liquidity needs.

If one uses the standard 60/40 portfolio as a starting point and wants to incorporate private equity into their asset allocation, the scenarios below can be used as a starting point (FIGURE 5). Funding a private-equity allocation from public equity can offer a reduced risk profile while offering a higher return potential and improved Sharpe ratio; this highlights the diversification benefits from the inclusion of private equity into a portfolio. Conversely, funding private equity from the fixed-income allocation also has the potential to increase return profile, but comes at the expense of an increased risk profile and less optimal Sharpe ratio-outcomes.

Tender-Offer Structure

While private equity can provide many potential benefits, individual investors have historically faced challenges accessing the asset class. The tender-offer fund structure provides a solution that opens up participation to a broader investor audience.

Private equity has traditionally been structured through private fund offerings, rather than as SEC-registered funds, thereby making them less accessible. Some typical and more burdensome characteristics of unregistered private funds include:

• Very high investment minimums (frequently $1 million or more)

• Long lock-up periods (often 7-10 years) with no interim liquidity

• Unpredictable capital calls

• Late tax reporting (Schedule K-1)

• Less frequent performance reporting (typically quarterly)

As a result of these structural limitations, private equity has traditionally been used almost exclusively by large institutional investors and ultra-high-net-worth individuals. This is where the tender-offer fund vehicle comes into the picture.

A tender-offer fund is a SEC-registered, closed-end fund that’s generally unlisted and provides periodic shareholder liquidity through tender offers. Since it isn’t subject to the 15% limit on illiquid securities to which mutual funds and ETFs must adhere, a tender-offer fund can invest more substantially in private equity, while also providing the following benefits that come with SEC registration:

• Lower investment minimums (as low as $25,000)

• Monthly subscriptions without capital calls

• Periodic liquidity at net asset value (tender offers typically conducted quarterly for up to 5% of fund net assets)³

• Improved tax reporting (Form 1099)

• Monthly performance reporting

Tender-offer funds can streamline the investment process for shareholders and are considered evergreen, enabling investors to subscribe in any given month and add to existing positions over time, with each subscription fully funded up-front. Conversely, unregistered private funds have limited offering windows, subsequent drawdowns, and stated end dates. This typically requires investors to develop and implement a complicated commitment plan in order to maintain their desired private-equity allocations.

Investors in tender-offer funds will typically still need to qualify as an accredited investor⁴ (or qualified client,⁵ depending on the fund) to be eligible to invest. While most tender-offer funds seek to provide quarterly liquidity for up to 5% of net assets, they aren’t required to provide shareholder liquidity. As a result, these types of funds are meant to be long-term investments and aren’t intended for investors with short-term liquidity needs.

While the tender-offer structure eliminates many of the hurdles in accessing private equity, individual investors should still consider seeking out a skilled manager.

While the tender-offer structure eliminates many of the hurdles in accessing private equity, individual investors should still consider seeking out a skilled manager with long-nurtured relationships in the private-equity marketplace.

Summary

Private equity investing offers a large and growing opportunity set with attractive risk and return enhancements to a diversified portfolio. Though private equity investing has historically been utilized by large pension plans, foundations, and endowments, the tender-offer structure provides the benefits of private equity to a wider range of investors. For investors that may benefit from an allocation to private equity, the tender-offer structure alleviates several drawbacks to traditional private equity investing, such as high minimums, lock-ups, illiquidity, and extra tax reporting complexity.