In the Age of Democratization, How Can Individual Investors Best Select Private Fund Managers?

The decision individual investors make about whether to invest in private assets may be much simpler than how to invest in private assets. There is a lot of data indicating that private equity returns, for example, exceed public equity returns over long periods of time. So, based on that information, if you are a sophisticated investor with sufficient liquidity and a long time horizon, it seems logical to allocate some portion of your wealth to private equity.

This rationale has been a driving force in the democratization of private assets. However, success depends on a number of elements. This article focuses on the importance of private asset manager selection and shares my insight, drawn from extensive experience managing private assets for a large global financial services company and its clients, on how to apply an “institutional lens” when choosing a private asset manager.

The concept of a funnel is used across many disciplines, including investment selection. Generally, we want a wide opening at the top of the funnel so that we can evaluate many investment opportunities and then narrow our choices by using clear criteria to select the handful of investments that best meet our goals.

The good news in private markets is that the top of the funnel can be incredibly wide – the SEC reports that there are at least 1,750 fund managers in the U.S. who manage about 7,500 individual funds,¹ and globally, it is estimated that there are presently about 13,900 private funds being marketed to investors.²

Much like the way the coffee aisle was overwhelming for Robin Williams in a favorite old movie Moscow on the Hudson, even the largest institutions could not examine over 13,000 funds a year, so they use guidelines to narrow down the list. Some institutions rule out first-time funds, some choose not to invest in emerging markets, some may be temporarily “full” on real estate, etc. Through this process, they are still left with a lot of options which they can then start to examine more closely and choose the ones that they think will generate the best risk-adjusted returns for their portfolios.

Currently, individual investors do not have the same wide selection as institutional investors and they may miss opportunities to invest in up-and-coming managers who may be on their first or second fund, or who are raising smaller funds to focus on niche strategies, both of which create the opportunity for differentiated returns.

For now, the limited number of private market options available to individuals raises some concern about whether they can replicate the strong investment experience that institutional investors have benefitted from, but it may only become more difficult to do as the options expand to create a much wider funnel and we are all chanting “private funds, private funds, private funds” as Robin Williams did about coffee. As a result, the importance of selecting a private asset manager will only grow over time.

Dispersion of Private Fund Returns Increases Risk for Less Experienced Investors

In his book Pioneering Portfolio Management, David Swensen stated that “in the absence of truly superior fund selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.”³ This is a significant statement from the then Chief Investment Officer of Yale University and the person most associated with creating what is commonly known as the “Endowment Model,” which allocates significant capital to illiquid, private funds. A lot has changed since Mr. Swensen wrote that in 2009, but the caution that he raised still exists.

We all accept that equity returns vary considerably from year to year, but our experience investing in public equity mutual funds shows a fairly narrow outcome relative to benchmark returns. For instance, for the 10-year period as of Q3 2021, J.P. Morgan reported that the variance from top quartile to bottom quartile for global equities was 1.8% (12.5% vs. 10.7%). In contrast, the variance of returns for global private equity was substantially greater at 22.9% (24.5% vs. 1.6%).⁴

For individual investors who will only make a handful of private fund investments, it is likely that their investment performance will vary significantly from their expectations. Consistently choosing the best private fund managers is not easy, and not being able to do so can result in materially lower investment returns.

Professionally-Advised Accounts Mitigate but Do Not Eliminate Manager Selection Risk

Inexperienced private markets investors can mitigate the risk associated with selecting a single fund by 1) investing in fund-of-fund products, 2) diversified co-investment products, or by 3) selecting funds from curated offerings of funds made available by professional advisors. While all three options can be effective, since there is still a single “manager” for each, significant manager selection risk still exists. It is critical, then, that investors understand the long-term experience and performance of those portfolio managers before committing to their products or their selected funds.

For example, a study by Cliffwater titled “Twenty-Year State Pension Performance Study (July 2021)” evaluated 41 plans over a 10-year period (2011 – 2020).⁵ It revealed that the dispersion of private equity returns was about twice the dispersion of returns for public equity portfolios, even though the median private equity returns were lower than U.S. public equity returns during the same period.

Benchmarking and Persistence of Fund Returns

Once an experienced investor narrows down the funnel of opportunities by applying their specific selection guidelines, the next usual step is to benchmark the performance of comparable funds to determine who the best (top quartile) performers have been. The primary metrics for benchmarking private funds have been their internal rate of return (“IRR”) and multiple of invested capital (“MOIC”), where IRR represents an investor’s annual return on invested capital and MOIC indicates the ratio of cash received from a fund to the amount of cash invested.

Recently, there has been increased focus on benchmarking private funds to public markets using a Public Market Equivalent methodology (“PME”) and providing this metric in addition to the IRR and MOIC. In short, PME takes the cash flows of a fund, or group of funds, and assumes that the cash flows were invested or divested from an appropriate public market index on the same days. The result is to compare the return that an investor in a private fund, or group of funds, earned versus what they would have earned if they had invested in the public markets.

Private Asset Benchmarks Need to Be Looked at on a Relative Basis

PME is a good way to compare public vs. private market returns broadly but does not provide sufficient guidance to an investor trying to decide which fund to select unless they have the PMEs for all of the comparable funds invested during the same period. For instance, if an investor chooses a fund that outperforms its PME by 2% p.a., they might be disappointed to learn that the median private funds available at that time outperformed the PME by 5% p.a., and they missed an opportunity to earn more. Similarly, IRRs and MOICs are insufficient metrics if considered in isolation, without comparing them to comparable funds invested during the same period.

Past Performance Is No Guarantee of Future Results

We are all familiar with the disclaimer that “past performance is no guarantee of future results” and this is certainly true with private market funds. While at one point, investors may have felt safe allocating to managers whose prior fund was a top-quartile fund on the basis of IRR or MOIC, or both, there is either varying support for that conclusion today, or insufficient data.

Within private equity, there is much less evidence of persistence for top-quartile funds today than a decade ago. For real estate, there appears to be short-term persistence (fund-to-fund) which dissipates over a series of funds for the same manager. And, there is limited data to make any conclusions for newer private fund strategies such as infrastructure and private credit. So, looking at a fund manager’s prior fund performance may not be a reliable guide for choosing whether to invest in their latest fund, and investors need to dig deeper.

Interpreting the Data Is a Challenge for Individual Investors

With the gap between public and private returns shrinking and a wide dispersion of private market fund returns still prevailing, it is more important than ever to consistently select the best private fund managers to attain the expected benefits of higher investment returns from private assets. As noted above, individual investors are often not provided with comparative information for private funds to make well-informed decisions. And, if they were, there is significant uncertainty about whether that information would be enough to guide them to make good investment decisions.

Benchmarking is one area where institutional investors and professional fund managers hold a significant advantage over individuals. Institutional investors not only have ready access to volumes of proprietary and purchased benchmarking data, but they also have decades of experience understanding the nuances of how to evaluate the data and make educated decisions. The next section describes some of the techniques that institutional investors use to select private fund managers and how individual investors can apply some of those techniques.

Applying an Institutional Lens to Private Asset Manager Selection

Institutional Process

Institutional investors narrow their selection process to managers in sectors where the investor has a strong conviction that they can earn above-average returns. They may favor infrastructure over other real assets, or over-allocate to defensive sectors, such as healthcare, within their private equity portfolio. A lot of factors go into the allocation decision, and it evolves over time, but once they have decided to make commitments within specific sectors, institutional investors meet with as many fund managers focused on those areas as possible.

In this part of the process, they are trying to determine whether the strategy and execution of a successful manager is repeatable in the current environment, or conversely, whether a manager who under-performed in a prior fund was unlucky or mistimed the market and is poised for a rebound in their current fund.

Institutional investors will benchmark manager returns with a clear focus to make an “apples to apples” comparison so that they can identify which managers have truly outperformed their competition. This process includes:

• Matching generalist funds with other generalist funds, sector-focused funds with the same sector-focused funds, or funds with a certain risk level against other funds with the same risk level.
• Comparing funds raised during the same period (commonly referred to as the “vintage year”).

Once they have an initial overview of the competitive landscape, institutional investors will start to dig deeper into what may have contributed to over- or under-performance:

• Has a manager overly used fund-level leverage to “juice” their returns?
• Has the timing of investments materially driven performance, or did a single deal materially benefit or hurt a fund’s performance?
• Has a single partner of the fund manager driven performance by sourcing the most successful transactions and is that individual still with the firm and committed for the long-term?

Institutional investors will also consider intangibles such as whether raising a larger fund will lead managers to invest differently than before (e.g., invest in larger companies) and do not have the same expertise that led to their prior success. Other intangibles such as team dynamics and staff turnover are often evaluated through multiple meetings with partners and staff of the manager and reference checks. Institutional investors will also assess operational controls and compliance with regulatory requirements.

Through extensive due diligence, which can last months, institutional investors will layer their qualitative analysis on top of the quantitative analysis to rank managers from top to bottom for expected future returns and then choose their managers.

Lessons for Individual Investors

While institutional investors may possess substantial resources for selecting private fund managers, individual investors can apply the same basic concepts to improve their choices and overall investment performance.

Many of these actions can be taken in advance of being “pitched” on a specific private asset fund:

• Similar to institutional investors, individual investors should start with a framework for asset allocation (equity, fixed income, and real assets) that will direct a search for managers.
• They should be clear about what level of risk they want to take within each asset category. For example, investors can target lower-risk, fixed-income-like returns in real asset categories by investing in “core” funds or higher-risk, equity-like returns in “opportunistic” funds. Similarly, private credit funds can run the gamut from high-grade fixed income to distress debt which may perform like equity. And private equity funds range from lower-risk less-leveraged buyouts to higher-risk early-stage venture capital.

Individual investors should then take advantage of any opportunities that are made available to interview the private fund manager or the professional adviser to dig deeper:

• If possible, get relative performance data compared to similar strategies and similar vintage years for closed-end funds and understand what may have driven over- or under-performance.
• Look closely at how prior fund returns were generated – did they rely on one or two investments to drive performance? Did the manager take some outsized “bets” that paid off, but would have sunk the fund if they were not successful? Has the fund used leverage to increase their returns and is that sustainable in a higher interest rate environment?
• Ask the manager and evaluate whether their strategy is right for the current market environment and why. For example, will a manager who has had great success investing in industrial real estate be able to pivot if you think that industrial is over-played and the real opportunity is now in multi-family or student housing?
• Ask about recent or expected personnel turnover and consider whether those individuals were important to executing the manager’s strategy.

Much of the above requires consistent effort and cannot be effectively executed by sporadically examining private asset funds. Therefore, the most important lesson for individual investors may be to continually stay educated on the private asset industry and build up the knowledge and experience to ask the nuanced questions to make thoughtful manager selections.

Sources

1. U.S. Securities and Exchange Commission, “Private Funds Statistics, First Calendar Quarter 2021” (November 1, 2021), Private Fund Statistics, First Quarter 2021 (sec.gov).

2. Or Skolnik et al., “Taking Private Equity Fund-Raising to the Next Level” Bain & Company, July 17, 2023, Taking Private Equity Fund-Raising to the Next Level | Bain & Company.

3. David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (Free Press, a division of Simon & Schuster, 2009), 224.

4. J.P. Morgan Asset Management, “Market Insights: Guide to Alternatives” (2021), 6, Guide to Alternatives.

5. Cliffwater LLC, “Twenty-Year State Pension Performance Study” (July 2021), 6, Twenty-Year State Pension Performance Study.