Just Say No

Adam M. Grossman  |  September 13, 2020

DOES WEALTH bring advantages? Yes—but it can also invite some unique challenges. Consider country music singer Kane Brown.

Shortly after moving into a new home, he went 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 on his own property. His backyard, if you can call it that, covers some 30 acres.

It seems wealth can make life more complicated. Another example: As your 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 appears to have grown. In the past, to protect everyday investors, private investments were limited to those who met certain net worth or income thresholds and, indeed, such investments were most common among university endowments and pension funds.

But now, thanks to industry lobbying, the government is broadening access. In a recent ruling, the Department of Labor threw open the doors 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 aren’t familiar with it, is a fund that invests in private companies. This is in contrast to traditional mutual funds, which invest almost exclusively in publicly traded companies. As enticing as private equity funds may seem, I see at least five reasons to steer clear of them:

1. 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 per year plus 20% of profits. By contrast, a simple index mutual fund might charge 0.02% of assets under management and not take any of the profits. Sound bad? It gets worse.

According to research conducted by The New York Times, private equity firms often deduct additional expenses from clients’ accounts without disclosing the costs. In 2015, private equity giant Blackstone paid $39 million to settle a case along these lines. Even when there is disclosure, it can be buried in the fine print. In 2014, for example, Kohlberg Kravis Roberts & Co. used $38.6 million of investors’ funds to help the firm settle a lawsuit. According to 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.

2. Transparency. In 2015, Harvard University’s endowment exited an ill-fated private investment. Years earlier, it had purchased 33,600 acres of timberland in Romania. But Harvard’s representative in Romania turned out to be dishonest, and the endowment overpaid for the land. This is also the kind of thing that’s 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, they’re subject to much more scrutiny, making it harder to engage in malfeasance.

3. Strategy. The purpose of private funds is to pursue strategies that are unusual. Oftentimes those work out fine—and sometimes very profitably. But when a fund is pursuing strategies that are farther from the beaten path, risk inevitably increases.

4. Concentration. In recent months, there’s 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’s manager, the concentration risk can be even greater. To the Department of Labor’s credit, it’ll only allow private equity investments into 401(k) plans when they’re 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 Core S&P 500 ETF’s holdings page. It couldn’t be more straightforward. By contrast, Partners Group, one of the private equity firms that lobbied the Department of Labor for the recent rule change, provided this holdings’ disclosure last month. It’s 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.

5. Returns. Despite the above drawbacks, haven’t some investors made a fortune with private funds? In other words, if the net returns are great, isn’t that all that really matters? 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 the consulting firm McKinsey illustrates the size of that gap. See exhibit four on page 11. As at least one industry participant has acknowledged, the best funds are reserved for the largest institutional investors, not individuals. This, ultimately, is my biggest concern with private funds.

Yes, I see the appeal of private funds. They offer a seemingly attractive alternative to staid stocks and bonds, especially at a time when the prospective returns on traditional investments look more limited. Still, I’d be cautious.

Adam M. Grossman’s previous articles include Eyeing the ExitMaking Time and Portfolio Checkup. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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