Does wealth provide advantages? Yes, but it can also invite some unique challenges. Consider country music singer Kane Brown. A little while back, shortly after moving into a new home, he went out for a walk. He told his wife he’d be back in half an hour. But seven hours later, after getting lost, he ended up calling for help. What was unique about this episode is that, the entire time he was lost, Brown was still on his own property. His back yard, if you can call it that, covers some 30 acres.
I had never heard of someone getting lost on their own property, but a common theme is that wealth can make life more complicated. Among other reasons, this occurs because, as one’s net worth grows, invitations arrive to participate in more complex investments. These might include hedge funds, private equity, startup companies and other seemingly attractive alternatives to stocks and bonds.
In recent months, with both the stock and bond markets in the U.S. near all-time highs, interest in private-company investments seems to be growing. In the past, as a protection for everyday investors, private investments were limited to those who met certain net worth or income thresholds. As a result, they were most common among university endowments and pension funds. But now, thanks to effective industry lobbying, the government is broadening access. In a recent ruling, the Department of Labor threw the doors open to private equity. Employers now have the green light to include private equity among the funds offered to their 401(k) plan participants.
A private equity fund, if you’re not familiar with it, is a fund that invests in private companies. This is in contrast to traditional mutual funds, which invest almost exclusively in public companies. As interesting as private equity funds may seem, however, I see at least five reasons to steer clear of them:
Cost. Private equity funds typically carry fees that are orders of magnitude higher than simple mutual funds. The standard has long been 2% of assets under management plus 20% of profits. In contrast, a simple index mutual fund might charge 0.02% of assets under management and not take any of the profits. But it gets worse. According to research conducted by The New York Times, private equity firms often deduct additional expenses from clients’ accounts without disclosing them. In 2015, private equity giant Blackstone paid $39 million to settle a case along these lines. And even where there is disclosure, it can be buried in the fine print. In 2014, for example, Kohlberg Kravis Roberts & Co. used nearly $40 million of investors’ funds to help the firm settle a lawsuit. According to the fund documents, this expense was permitted, and it was disclosed. But as the Times notes, that disclosure was on page 35 of a 37-page report. These may be the exception rather than the rule, but the private fund framework makes it easier for this sort of thing to happen.
Transparency. In 2015, Harvard University announced that its endowment was exiting an ill-fated private investment. Years earlier, it had purchased 30,000 acres of timberland in Romania. But Harvard’s representative in Romania turned out to be dishonest, with the result that the endowment overpaid for the land. While most people are honest, this is also the kind of thing that is more likely to happen with a private investment. And if Harvard’s endowment—the largest in the world, with hundreds of employees—can be deceived, it can happen to anyone. Of course, public companies aren’t perfect. But in general, public companies are subjected to much more scrutiny, making it harder to engage in malfeasance.
Strategy. The purpose of private funds is to pursue strategies that are unusual. Oftentimes they work out fine—and sometimes very profitably. But when a fund is pursuing strategies that are further off the beaten path, risk inevitably increases.
Concentration. In recent months, there has been concern about the S&P 500 because its largest constituents have appreciated significantly while many of its smaller constituents have dropped in value. The result is the top 10 companies in the index now account for almost 30% of the total. The concern is that this diminishes the diversification benefit. But with a private investment fund, where investments need to be hand-picked by the fund manager, the concentration risk could be greater. To the Department of Labor’s credit, they will only allow private equity investments into 401(k) plans when they are part of a larger, diversified fund, such as a target-date fund. This ensures that no investor can allocate all their savings to private equity. Still, to the extent that investors have any private equity exposure, there is concentration risk. And disclosure documents aren’t much help. If you look at the web page for a simple index fund, it’s easy to understand what the fund owns. See, for example, the iShares S&P 500 fund’s holding page. It couldn’t be more straightforward. In contrast, Partners Group, one of the private equity firms that lobbied the Department of Labor for this rule change, provided this holdings disclosure last month. It is the opposite of straightforward. To be clear, the Partners fund might be a great investment. The problem is that, as an individual investor, it’s very hard to know.
Returns. After reading through the above concerns, you might still be wondering: Despite these drawbacks, haven’t some investors made a fortune with private funds? In other words, despite the cost and the risks, if the net returns are great, isn’t that really all that matters? Yes, to some extent that’s true. But the problem with private funds is that they aren’t all created equal. Some are much better than others. And the difference between the best and worst among private funds is much greater than the difference among public funds. This report from consulting firm McKinsey illustrates the size of that gap (see exhibit 4 on page 11). And as at least one industry participant has acknowledged, the best funds are reserved for the biggest institutional investors, not individuals. This, ultimately, is my biggest concern with private funds.
I do see the appeal of private funds. They offer a seemingly appealing alternative to staid stocks and bonds, especially at a time when the prospective returns on traditional investments look more limited. But for the reasons discussed here, I would be cautious.