Bridging the Gap
Bring your clients the same private equity investment opportunities as those historically available only to large institutional investors.
Backdrop
Institutional investors increasingly view private equity funds as an attractive asset class due to the potential for outsized returns, inherent diversification and low correlation characteristics relative to public markets. Additionally, private equity fund structures mitigate risks associated with the behavioral biases associated with public market investing, which often lead investors to buy high, sell low and react adversely to market volatility.
The scale and experience of institutional investors gives them significant advantages compared with high net worth investors in terms of carefully constructing intelligent portfolios of best-in-class private equity funds. Institutions invest in private strategies by establishing asset allocation targets and then sourcing a diversified set of managers across strategies, sectors, geographies and vintage years. The process is arduous and if built from the ground up, it can take years for portfolios to reach their desired target allocations.
As exposure to private equity is generally not available through mutual funds or separately managed accounts, and commitment requirements are typically $5 million to $20 million per fund, private clients are not able to follow the systematic institutional model of setting a long‐term allocation policy.
Individuals, however, typically lack the capital, resources and relationships necessary to access, conduct due diligence on and manage a steady allocation to private strategies.
For optimized diversification, individual investors, like institutions, require the ability to have regular and ongoing access to a series of private equity funds from a variety of managers to achieve appropriate levels of vintage, strategy, geographic and ‘shop’ diversification.
Financial advisors can add substantial value by finding a private equity platform that is committed to bringing quality new funds over the course of each year with minimum capital commitments, sized to enable vintage year-over-year diversification. All this must be specifically designed to meet the portfolio construction needs of private clients. By utilizing these types of private equity platforms advisors can select funds that both diversify client portfolios and complement existing investments.
Not all Private Equity Fund Solutions are Created Equal
However, it is critical to understand that not all private equity platforms and structures are created equal, and that structures such as funds-of-funds and access platforms are riddled with shortcomings, all of which Crystal Capital Partners resolves.
In the past, individual investors have allocated to private equity through registered and unregistered private equity funds-of-funds. This structure enables investors to participate in an actively managed portfolio of private equity funds at substantially reduced minimums with thorough diversification. However, private equity funds-of-funds are ‘one size fits all’ and tend to be overly diversified in order to offer enhanced liquidity for the pool which often results in diluted returns.
Research supports the view that the popularity of private equity funds‐of‐funds is waning. Private equity funds-of-funds made up 18% of private equity funds closed in 2007 and accounted for 15% of capital raised; by 2016 these figures had fallen to 10% and 7% respectively, and stand at 9% and 4% in November, 2017. Since December 2008, the overall assets under management (AUM) of private equity funds‐of‐funds has grown from $266bn to $381bn, a 43% increase; however, the rest of the private equity market has grown by 81% over the same period¹.
Funds‐of‐funds businesses have been under a great deal of pressure to evolve over the last decade. Much has been made of the low returns that broadly diversified funds‐of‐funds products have served up, not to mention the lack of flexibility as investors don't necessarily want an off-the-shelf product. They want customization².
One size does not fit all. This is where Crystal steps in and this is why Crystal in 2009 evolved from a traditional fund-of-funds structure to a turnkey hedge fund and private equity platform for advisors, creating separately managed customized portfolios for advisors and their clients.
Amid an ever-evolving landscape, access platforms have evolved away from the fund-of-funds model to enable high-net-worth individuals to invest in private equity with substantially reduced minimum commitments on a one-off basis. However, a non-systematic approach prevents private clients from enjoying the benefits of an appropriately constructed and diversified portfolio. Despite the importance of a thoughtfully developed allocation plan, very few private equity platforms are equipped to provide access to elite managers over multi-year periods within an intelligent and cohesive framework to optimize risk and reward.
An Institutional Approach to Portfolio Construction for your QP Clients: the Crystal Way
1. Conflict – Free Institutional Manager Selection
Manager selection and investment/operational due diligence are essential elements in managing private equity portfolios. The potential difference in outcomes is larger than in any other asset class. In private equity, it is the difference between meeting one’s return goals and falling short.
Manager selection at Crystal is driven by our experience in identifying those who have navigated multiple market cycles. Our selection process is conflict-free as we are not compensated by any of the managers in the program. This allows us to be poised side-by-side in alignment with advisors and their clients.
Effective private equity investors typically find that the best strategy is to focus on finding experienced managers who can take advantage of favorable investment conditions when they occur (effectively, buying low, selling higher, and taking advantage of secular growth along the way). It is also important that these managers have the networks, discipline, and industry expertise to avoid overpaying in frothy markets, develop and execute clear value creation plans at portfolio companies, and identify the most accretive selling opportunities in any given market environment.
The value-added potential of private equity manager selection is substantial. The figures below show the spread between the average and the 25th percentile US buyout fund from 2007 to 2018³. The potential impact of selecting better performing managers cannot be emphasized enough. Avoiding poor performers is an important element of generating satisfactory returns from this asset class.
Top-quartile funds still outperform the average by a wide margin ³
Moreover, private equity has demonstrated an outsized persistence of performance, as measured by the likelihood of successor funds to deliver the same quartile of performance as their predecessors. LPs can trust that a PE firm that excels with its first fund has a greater chance of replicating that success with the next fund. For GPs that have managed a top-quartile fund, there’s a better than 6-in-10 probability that their successor fund will also be an above-average performer³.
Looking ahead to the likelihood of more volatility in public markets, investors remain focused on the relative outperformance of private equity. In a recent global survey of LPs by Preqin, 90% of respondents said that their PE investments met or exceeded their expectations over the past year. And 83% said that their confidence in fund performance has either not changed or increased. Through economic thick and thin, private equity has delivered remarkably stable returns³.
Private equity continues to meet investors’ expectations³
2. Strategy Diversification
With Crystal’s private equity platform, and a conflict-free manager selection process, advisors and their clients have the flexibility to choose where in the lifecycle of a company they would like to invest. Viewing the life cycle of a company in terms of its cash-flow generation abilities, there is a continuum of strategies that are available on Crystal’s private equity platform.
Private Equity Landscape in the Business Cycle Framework ⁴
Venture capital begins with early stage, pre-revenue companies and extends through late stage when a company develops a product and begins generating revenue.
Growth equity is the next phase, when the risk shifts from whether a product will work to whether it can gain market adoption. Such companies might not be cash-flow positive at the point of investment but would be expected to be so at the point of realization.
Buyouts of cash-flow-generating companies are grown from small market to middle market to mega buyouts. Larger companies are typically considered safer and more stable, with broader diversified cash flows, but this is reflected in higher valuations. Buyouts may be financed with mezzanine debt. Mezzanine funds also tend to have equity co-investments.
Distressed and turnaround strategies usually involve companies that have gone into decline.
3. Vintage Diversification
What does ‘Vintage’ mean?
A typical private equity fund has an initial duration of 10-12 years. This can be segmented into an investment period during which capital is called and put to work (typically the first five years), and a subsequent harvesting period during which the fund looks to exit already existing investments and return capital to limited partners. The ‘vintage year’ of a private equity vehicle refers to the year in which the initial influx of capital is first delivered to a project or investment. The vintage year of a fund, and the phase of the business cycle in which the vintage year occurred, is highly determinative of the performance outcome realized by the fund.
The element of timing certainly has an impact on private equity outcomes. That is why diversification across vintage year — the year of inception of a partnership — is an important element of private equity investing. Macroeconomic conditions, asset pricing, capital market issues, and other trends can influence the success of a strategy initiated at a specific point in time. Diversification across time and tilting a portfolio to benefit from favorable trends or avoid unfavorable ones in a given vintage year can improve the odds of success. One important element of vintage year diversification is the disciplined, steady deployment of capital. Investors cannot time the market in private equity any better than in traditional investments. To build and maintain an allocation is also difficult with episodic participation. The most successful investors take a very consistent approach, and this is considered best practice in the private equity space ⁴.
Allocating across vintages also allows an investor to build out a systematic private equity program that eventually becomes self-funding by producing a distribution stream that can be reinvested (or distributed as income).
Laddered consistently and periodically (vintage diversification), a systematically designed private capital portfolio should produce a staggered series of consistent cash flows and liquidity events for an investor. Cash flows can be accelerated with the inclusion of private credit and real assets.
Investors seeking to build a diversified private equity allocation may wish to consider a vintage investing program constructed with vintage-specific, multi-manager funds. These funds typically provide access to carefully vetted private equity funds within a single vintage year. By including multiple vintage year funds in a private equity allocation, investors can gain diversified sector and vintage exposure, often at lower investment minimums. By utilizing Crystal’s private equity platform, financial advisors can create their own diversified portfolios custom-tailored to needs of each of their existing high net worth clients as well as to win new business through the elimination of the aforementioned barriers to entry.
4. Streamlined Portfolio Implementation and Management
For most investors, the implementation and management of a private equity portfolio allocation is a constant process of adding to the portfolio to maintain the exposure. The resources required to do this can be substantial and tend to be a key consideration in determining the best route for implementation. ⁴
These resources compound with multi advisor clients owning multiple custom portfolios and a fully integrated private equity platform to invest and monitor these portfolios is essential. Working with a platform partner that is continuously sourcing institutional funds allows advisors to focus on investment management, their clients’ on-going objectives, and not simply due diligence.
Crystal equips advisors with the necessary portfolio building tools, thus enabling them to efficiently allocate their clients' capital to desired private equity exposures.
5. Solving Operational Complexities
The ongoing management of a diversified private equity portfolio involves the provision of capital to fund new portfolio investments during the investment period and receiving distributions upon the sale or realization of a portfolio investment. Typically, underlying funds issue capital calls with a 5 to 10 day notice. These capital calls will occur irregularly over the 3 to 5 year investment period of a fund. A single fund will generate a significant number of capital calls and distributions over its life.
Crystal’s private equity platform helps ease the operational burden by providing consolidated capital calls and distribution notices for every investor. Consolidated capital calls are typically issued quarterly with 15 days’ notice.
The portion of capital that has not been called, should be held in relatively liquid securities in order to satisfy future capital calls.
Typically, valuations are provided 45 to 60 days after the end of a quarter and up to 120 days after year-end. Every portfolio on Crystal’s private equity platform will receive its own audited financial statement from Ernst and Young. Audited financial statements are available by June 30th.
Taxable investors will receive a consolidated schedule K1. Estimated schedule K1s are available in early April and final schedule K1s will be available around August.
Sources:
Leveraging our platform enables you, the advisor, to intelligently expose your QP clients to private equity in the same manner as the most sophisticated institutional investors.