The Bizarre Rationale Behind Private Equity Funds 

Vanguard, that folksy company that has so successfully catered to middle-income investors for most of my adult life, is opening a private equity fund.

It’s part of an attempt to “broaden the company’s appeal… to larger investors,” a company spokesperson said.

I understand why they would want to do that. What I don’t understand is why anyone would want to invest in it.

My objection is not about Vanguard but about the asset itself.

A private equity fund is like a mutual fund. But instead of owning stocks, it buys shares of private businesses, including start-ups. When a new business succeeds, there is often a period when their growth is extreme – 100%, 200%, even more in a single year. Link several such years together and you could, in theory, dramatically multiply your money.

So that’s the allure.

What’s the reality? I’ll get to that in a moment. First, let’s talk about fees.

The average actively managed equity fund (your bread-and-butter mutual fund) charges about 1% a year in management fees. That’s $1000 in annual fees for a $100,000 account.

You can pay considerably less than that by investing in an index fund. An index fund is basically a basket of stocks meant to track the ups and downs of the stock market. It’s not actively managed, so the fees are considerably lower. It’s possible to find index funds with an expense ratio of 0.1%. That’s only $100 in fees on a $100,000 account.

Private equity funds typically charge a yearly management fee of 2%, plus an incentive fee of 20% of the profits.

That $2000 in management fees for a $100,000 account plus $200 on every $1000 of profits.

Let’s look at how these expense ratios work out under different scenarios…

Scenario One 

In year one, the portfolio appreciates 10% – from $100,000 to $110,000.

In an index fund, your fee would be one-tenth of 1% or $110. You’d be left with $109,890.

In an actively traded mutual fund with a 0.1% expense ratio, your fee would be $1100. You’d be left with $108,900.

And in a private equity fund, you’d pay $2000 for the management fee and another $2000 based on 20% of the $10,000 profit. You’d be left with only $106,000.

Now you might think that the $3000 difference between an actively managed mutual fund and an actively managed private equity fund is a small price to pay for the “privilege” of being able to invest in private start-ups. But before you come to that conclusion, consider how this “mere” 3% difference adds up over a career of investing.

Scenario Two: A Longer View 

The historic return on the market for the past 100 years has been roughly 9% to 11%. Let’s use 10% to make the arithmetic easier.

A hundred grand appreciating at an average of 10% over 40 years will become about $4.5 million.

In an index fund with a 0.01% fee, you’d keep about $4.4 million of that, paying out about $100,000 in fees over 40 years.

In a “regular” actively managed equity mutual fund with an expense ratio of 1%, you’d end up with only $3.1 million. Which means you’ve paid the fund managers $1.3 million in fees.

And in a private equity fund where you’re paying a yearly fee of 2% and 20% on profits, you’d have, at the end of 40 years, something like $1.6 million. Meanwhile, the fund has collected $3 million in fees!

So why would anyone want to invest in a private equity fund?

There’s only one logical answer: Because they expect the fund to exceed what they could get elsewhere. And exceed it by at least 5%.

So, back to that $100,000 over 40 years…

Let’s say that instead of producing the historic average return of 10% a year, the private equity fund got you twice that – 20%, or 16% after all fees and expenses. Then, instead of making the $4.5 million you could have made on an index fund averaging 10%, you’d be left with something like $37 million.

Again, that’s the allure of private equity for investors.

What are the chances of getting those sorts of ROIs over any length of time?

Next to zero.

Private businesses, when they are successful, often double and triple their value over a period of 3 to 4 years. Some of them continue to grow at 20% to 30% for several more years, and again at about 10% for another 5 to 10 years, before settling at 2% to 5%.

If you get enough of these sorts of companies in one basket, you can experience phenomenal results. But it very rarely happens.

There certainly are some private equity funds that do well. But like mutual funds, they are the exceptions. According to Oliver Gottschalg and Ludovic Phalippou, writing in a recent issue of theHarvard Business Review,“PE funds have historically underperformed broad public market indexes by about 3% per year on average.”

So, again, why are people interested in them?

I can think of three possible answers.

1. Private Equity Funds Are Allowed to Distort Their Performance 

As noted in the HBR article: “Private equity returns are often reported as the internal rate of return (IRR) – the annual yield on an investment – of the underlying cash flows.

“This implicitly assumes that cash proceeds have been reinvested at the IRR over the entire investment period – that if, for example, a PE fund reports a 50% IRR and has returned cash early in its life, the cash was put to work again at a 50% annual return. In reality, investors are unlikely to find such an investment opportunity every time cash is distributed.”

This distorts results immensely. It allows PE funds to project triple-digit returns when the reality is much, much less. For example, the “top performing PE fund in one study showed a yearly profit of an astonishing 464% per year. But when the same projections were run using a still optimistic 12% ROI for those gaps, the yearly ROI dropped to 31%.”

2. Private Equity Funds Are Prestige Items

A $65,000 Richard Mille watch doesn’t work any better than a $35 Seiko, but it sure buys you a lot more prestige. Private equity funds are prestige products for ostentatious rich people.

And the fact that private equity funds are exclusive – that only “qualified” investors are allowed to invest in them – adds to the prestige.  (A “qualified” investor, commonly referred to as an accredited investor, is an individual/entity that is legally permitted by the SEC to invest in hedge funds, venture capital funds, private equity offerings, and other private placements. These investors need to demonstrate a sufficient income or net worth before they are allowed to purchase unregistered securities.)

3. Rich People Are Dumb, Arrogant, and Lazy 

Now here’s something you may not know about rich people as investors. Although they aren’t any smarter than non-rich people, they think they are.

Having big houses and lots of money in the bank, they begin to believe what others believe about them – that they have a better understanding of business, economics, finance, and investing than the average person.

But they don’t.

And since they don’t know much about any of those things – and because they are too lazy to figure it out themselves – they prefer to invest their money in funds.

And, finally, because they are arrogant, they are drawn into the allure of private equity funds. Private equity funds understand that and cater to it.