Equity Edge: Strategic Insights on Private Equity Investing with Wrug Ved

Stacie Jacobsen: Thanks for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. I'm your host, Stacie Jacobsen.

Over the past 20 years, private equity has generated almost double the return of public stocks. Now with 85% of U. S. companies being privately owned, Private equity exposure can add value to a diversified portfolio. Our guest today is Wrug Ved, a senior investment strategist here at Bernstein who focuses on the alternative investment landscape.

Wrug, thanks so much for joining us.

Wrug Ved: Thanks so much, Stacie. Happy to be here.

Stacie Jacobsen: Let's start with setting the landscape. Private equity has grown significantly in the last few decades. It originally was more of a niche institutional asset class, one that was accessible to these large university endowments. But today it's really more accessible to the traditional investor.

So, so can you start us off by talking about the key characteristics of private equity?

Wrug Ved: Yeah, absolutely. I think it's great just to set the table and kind of defining what is private equity, and private equity very simply is taking part of the ownership of privately owned businesses, uh, businesses that are typically acquired by private equity funds that are raised by private equity managers, where, you know, the investors in the private equity funds end up having ownership.

In let's call it 10 to 20 companies that that one private equity fund ended up acquiring for their underlying lines. You know, one of the reasons why we think that private equity is very attractive and has generated the type of returns that it has in the past is because when private equity firms acquire these privately owned companies, oftentimes they're acquiring them from the entrepreneurs that founded those companies in the first place.

There's just a lot more companies that are out there for private equity firms to potentially consider acquiring. So just to throw some statistics out, there's about 4,000 publicly traded companies in the United States that have greater than let's call it a hundred million dollars of annual revenue. Um, whereas there's over 600,000 privately owned companies that have greater than a hundred million dollars of revenue a year, so there's just a much bigger sandbox to play in, in terms of being able to find diamonds in the rough and trying to find opportunities for these private equity firms to find great companies that really have meat on the bones.

For them to grow those companies even better when it comes to like a revenue and profitability standpoint going forward, if the private equity firm were to acquire them and improve them from within…

Stacie Jacobsen: What are some of the benefits to investing in private equity?

Wrug Ved: So historically the returns have been far superior.

So, if I look at the last 20 years, the publicly traded markets, so the S&P 500 here in the U.S. the benchmark attracts the largest 500 Companies in the United States that index has done very well. It's grown by 9.6% per year over the past 20 years. Whereas the median private equity manager has grown by about 13.6% per year. So, there's been a premium of 4% per year of investing in private equity versus investing in public equity. So, the returns have been better and we expect that to continue going forward. But another reason why private equity plays a great role in client portfolios, not only the better returns, but really how it behaves from a valuation standpoint in periods of market stress.

So, when you look at the periods of the stock market going through sharp corrections, so when you look at the dot com bubble, or you look at the global financial crisis in 2009 or COVID in 2020, the stock market was down anywhere from, you know, 30 to 50% during each of those episodes, but over those same episodes, if you're an investor in these private equity funds the value of your private equity investments were, were much better behaved, down, you know, a fraction of what publicly traded stocks were. So, you know, we think that private equity can play a great role because owning private equity can really help you ignore some of the volatility that's happening around you.

Stacie Jacobsen: So, what's the why behind the premium? What are the drivers of return?

Wrug Ved: So that's a critical question because we know when we recommend investments, we're not just looking at what's done best in the past and then just trying to pile into what's done well recently. We're looking to see are those returns sustainable going forward.

And one of the reasons why we do think that returns and private equity will continue to show a premium to publicly traded stocks is that when private equity firms look to acquire companies, oftentimes they're looking to engage in a business plan to be able to improve those companies from within. So that business plan can take many forms.

Oftentimes it can mean growing that company both organically and inorganically. Oftentimes some companies that they're acquiring are regional based. When you think about fast food franchises or position groups, those are businesses that have the ability to do what's called a rollup strategy, where you are able to combine the company that you just acquired with like kind organizations in the similar industry, kind of get the benefits of economies of scale other times.

And business that's been very well run and grown by an entrepreneur haven't yet addressed some of the best practices in that industry that the company's in. So, to the extent that a private equity firm can help a management team implement some best practices, like using customer relationship management software, making the expense side of the income statement more efficient by cutting unnecessary costs or trying to do more with less, you know, that can be another way that private equity firms are able to increase profitability when they take over control of these companies The last thing that I would say and maybe one of the best ways that private equity firms add a lot of value is by being able to parachute in new and fresh management to a company and management that's been a proven turnaround agent in the industry of the company that was just acquired.

So Private equity firms often have at their disposal management teams that they've worked with in the past that have successfully grown companies and to the extent that one of these management teams can be plucked out of their old company and put into their new acquisition and run that same playbook and rinse and repeat this the same type of strategy that they successfully deployed to their previous investment.

That's another great way why private equity firms have the ability to generate better returns in the companies that they're acquiring.

Stacie Jacobsen: Right. So not all PE funds are the same. Manager selection does play a critical role in the total return of the fund. As we were just talking about the premium that the asset class in general has had over the public equity markets, but there's also a significant dispersion among managers, right?

And so, unlike the public market, so, there's also this kind of tighter correlation between a manager's past performance and their future performance. And I think we can all say that that correlation is relatively weak at best in these public markets. So, can you elaborate a little bit on the importance of manager selection?

Wrug Ved: Yeah, we believe manager selection is critical to being a successful private equity investor. What we mean by manager selection is that private equity is not a monolith. There's no index that you can invest in. There's no ticker, you know, like SPY, they can get you access to the S&P 500, where you're automatically invested and automatically just own the index.

So, in private equity firms, if an individual investor or an institution wants to get access to this asset class, they have to invest in the S&P 500. With managers, they have to invest in funds that are being raised by managers. And in any given year, when you look at all of the funds that are raised by the thousands of funds that are out there in the thousands of managers that operate these strategies, the dispersion between the best returning manager and the worst returning manager In any given year is wide enough to drive a truck through. So, to give you a sense, you know It's normal for the tracking error or like the amount of dispersion For a publicly traded stock manager to be within like a band of, let's say 3 or 4%, so like the best performing stock picker would've had a return, that's about 4% better than the average manager.

But in the case of a private equity fund, the results between, you know, the top quartile and the bottom quartile of private equity fund managers can often be 20 to 30% different. So, it really is the obligation of the allocator to make sure that you're able to invest in managers that are at the median or hopefully even above that median of how the industry is performing overall, because while there has been great returns for those investors that have been able to invest in the median or better of the private equity universe, you know, the returns for bottom quartile managers, it doesn't actually show any premium whatsoever. So, at that point, you're not even getting rewarded as an investor for stepping into illiquidity, like you would normally expect to get rewarded to do so.

Stacie Jacobsen: So that sounds a little bit easier said than done though. So how does an individual investor evaluate a manager of a fund?

Wrug Ved: So, one of the things you mentioned was that past performance isn't an indicator of future success. They do have a footnote that is very well warranted in a lot of the regulatory compliance driven footnotes for any financial firm. And while that is true, one area where we think that, you know, past performance does have actually a little bit of indication for future success is in the private equity space. And I'll give you a great example of why that might be the case.

So if I'm a founder, if I'm in an entrepreneur of a company and I put my blood, sweat and tears in growing that organization over the last 20 years, and it's really like, you know, my baby that I, you know, nurtured and fed and when they were sick and got them through the other side, and now I'm in the process of parting ways with it, and I'm running an auction process to sell this company.

Now I run an auction and I get a number of bids through my investment banker that I hired, you know, the way that those auction processes work in the way that a typical private equity deal is structured is that about 70 to 80% of the purchase price is paid up front, but the remaining 20 to 30% of the purchase price is in what's called retained equity, where the original entrepreneur doesn't take all of their money off the table, they have an amount that they roll over and they retain in the company going forward. Now, if I'm a founder and entrepreneur, that's about to sell my company and I still have skin in the game because of this retained equity. Who am I going to sell to? Am I going to sell to the person that has, you know, a 5% higher purchase price?

Or am I going to sell to someone that has been successful of growing businesses? Just like my own, where I'm confident that they're going to be able to do even better with the company that I nurtured and raised over time, I'm also going to, to sell to someone that has that confidence that isn't going to ruin, you know, the company that I put so much of my sweat equity into.

So that's one reason why we think private equity firms do have, you know, the ability to have a continuation of their past success because of some of the advantages they have during company auction processes.

Stacie Jacobsen: This might be an area where success begets further success.

Wrug Ved: I'd say so. But when it comes to an investor that wants to get access to private equity, one of the things that is difficult is that not all funds are open to new investors at all times.

And some of the best funds that are out there, the ones that are in the top quartile, you may not even be able to get into those funds because, you know, some of the best funds that are out there, every time they raise a new vintage year, they offer it up to their previous investors. And sometimes when they offer that new fund to previous investors, they're already oversubscribed and there's more demand than there is supply for the fund.

And they actually cut people back, let alone taking anyone new in. So, another key component to being a successful private equity investor is being able to get access to some of the most exclusive funds who may not even be open to new investors that haven't invested with that fund complex.

Stacie Jacobsen: I see, you know, I want to talk a little bit about what's going on in the current environment.

There are some industry observers that claim that higher returns earned by private equity are really generated through excessive leverage. Do you think that criticism is valid?

Wrug Ved: So private equity managers employ all different types of strategies. There are some managers that do look to engage in arbitrage that couldn't be available from time to time where, you know, they're acquiring a firm that's a great steady cash flowing company.

And if they can borrow very cheaply, they can earn a spread where they're able to get the advantage of cheap financing to be able to make unspectacular unleveraged results into far more attractive leverage results. Now, I would say that was the playbook for a lot of the early days of private equity. So as people remember in the late 80s, RJR Nabisco was taken private by KKR.

It was written up in the book Barbarians at the Gate and you know, that was fueled by the high yield bond industry that was, you know, new and the birth of the junk bond created ways for LBO firms and private equity firms to be able to use, you know, these kind of highly leveraged private equity strategies.

And there are a few organizations that still run that playbook very successfully. Now, in the world where we're in today, where the cost of borrowing is a lot higher than it used to be, both as a result of higher floating rates and higher spreads that lenders are looking to make on loans to private equity firms, I think that playbook is a little bit more challenged than it was, let's say, you know, five or six years ago when the cost of financing was a lot more attractive.

But one of the areas where we find just a lot more sustainability in the way that private equity firms can earn their return is those firms that don't use as much leverage. So typically. You know, there may be a misconception that all private equity firms, you know, lever up these businesses to like 60 to 70% LTV.

But in reality, most of the acquisition financing that private equity firms use is usually capped out at a 35 to 45% range of the value of the company. So when you think about putting a 20% down payment on your home. This is more like putting down a, you know, 60 to 65% down payment that the private equity firms have quite a lot of skin in the game.

So, I wouldn't describe this as excessive leverage.

Stacie Jacobsen: You know, the other thing that's talked about a lot is all of the money that's been raised by PE firms, and there's really just too much dry powder chasing too few deals. So, what do you think the repercussions of that are? Do we expect the premium over public equities to narrow?

What might happen?

Wrug Ved: It's a fair criticism when you look at just the amount of dry powder that's out there. So based on the latest, uh, data that we see, there's about $1.2 trillion of dry powder out there, which has grown quite a lot, and, and dry powder is just a measurement of how much funds have been raised by private equity firms but not been deployed into their acquisitions yet, so it's kind of the war chest that they're sitting on to go out and look for deals.

Now, there's a couple things that I would say about that. The first is that when you look at the value of the companies that private equity firms are acquiring, because, you know, companies are just more profitable today than they were 5 or 10 years ago, when you look at the amount of months of supply, meaning how long would it take to deploy that based on their actual deal activity, we actually don't see as much of an elevation in the amount of dry powder that they're sitting on because when they're doing deals, because these companies are more valuable, it's not like they have to do three times as many deals because companies are now value twice as much.

So, we think that there it's not as bad as it may seem at the surface level. Another thing that I would say is that we've heard these arguments for quite some time over a decade now that private equity is sitting on too much dry powder. There's not enough deals. And when you look at the results in terms of how private equity has held up and have returns deteriorated at all relative to the public equity markets, and we haven't seen that type of deterioration.

In fact, the last 10 years, the premium that private equity firms added to publicly traded stocks was actually above average, um, relative to previous decades, but it's definitely something that continue to monitor as an allocator to make sure that the private equity firms aren't raising too much that they can actually successfully deploy.

Stacie Jacobsen: Okay. So, let's take it back to the investor now, what should a family be thinking about if they want to consider adding private equity to their portfolio?

Wrug Ved: So the first thing that I would say is work with your advisor that you use to help manage your, your overall strategy. And making sure that you size your private equity investment properly.

You know, the biggest pitfall for investors investing in private equity is not sizing it appropriately. So, what I mean by that is, you know, unlike investing in stocks and bonds, where those investments are, are daily liquid, you're able to change how much you have invested in those asset classes on a daily basis.

When you commit to a private equity fund, there really are no takebacks. Once you make a commitment, you're on the hook to fund those capital calls based on your commitment amount. And one thing that many investors might be tempted to do is to do quite a lot of private equity because the returns are attractive and returns have also been very stable over the years.

But for us, you know, mere mortals that aren't, you know, the Harvard endowment or the government of Singapore sovereign wealth fund, you would like to eventually earn the benefit of, of all of the wealth that you've generated. So, you don't have the ability necessarily to think about the same time horizon as some institutions do.

So, we think sizing private equity in a reasonable way, but not going overboard is critical. So that's one piece of advice that I have. And the second thing is thinking about investing in private equity. In a way that is consistent with the way the institutions do, and by that, I mean, thinking about diversification across managers, there's a lot of great managers out there.

Some of them are specialists in a certain industry. Some of them are generalists, but also diversifying your vintage year exposure. There are some vintage years of private equity that are spectacularly good, and there are some that are actually very poor. So, spreading out your bets in private equity over subsequent years is a critical thing that I, you know, we recommend for clients to think about.

And the last thing that I would say is really kind of having that long term view. Private equity is not an asset class that you can time. We think that private equity is an investment that is meant to be something that will earn a significant benefit if you stay invested. So it's not one of those investments where we think that, you know, now is a good year and then future years will be four years.

You won't know that until the private equity investment has kind of run its course after a 12-year period of time. So, kind of having that long term focus on manager selection and manager access, we think will lead to a positive result.

Stacie Jacobsen: I hear you loud and clear that the exposure to private equity should really be something that an investor works out with their advisor based off of their specific profile.

But if I could ask you just in general, when you think about a typical exposure to private equity, can you give us a range of what that might look like?

Wrug Ved: Yeah, the way we think about it here is that for someone's core capital, so kind of what they need to live off in their lifetime to be able to achieve their spending goals in order to feel confident that they'll have enough to be able to sustain their lifestyle for the remainder of their life expectancy, you know, we think a very reasonable range of private equity should be in like, let's say the 3 to 6% weight in your overall asset allocation.

But for surplus capital, so that's like the amount of capital that's multigenerational in nature or assets that you'll likely give away to charities upon your passing for that amount where the time horizon is a lot longer and you don't need access to those funds most likely, you know, we think a range in the 5 to 10% level of your overall balance sheet.

It's also a very reasonable allocation to think about.

Stacie Jacobsen: Okay, that's helpful to get a perspective on it. But I do want to clarify, right, we're just talking about the private equity exposure in the portfolio, not the overall alternative investment exposure.

Wrug Ved: Oh, yeah, absolutely. You know, when we think about total alternative exposure in a client's core allocation, something in the 20 to 25% range, when you think about private equity, as well as commercial real estate, uh, private lending strategies, hedge funds, that's a very reasonable number. And then for a surplus, you know, even going up to the 35 to 45% uh, we think is a very reasonable number, but, but when you think about private equity: smaller than that.

Stacie Jacobsen: All right. That's helpful. We talked about multi-generational wealth.

Is there really ever a time where you might advise against somebody taking on private equity based off of their profile?

Wrug Ved: So, you know, investors that have a very high spend level, that's an area, yeah, where it's very difficult to size private equity because a balance sheet is shrinking over time. So, you know what you want to think about what is the long term value of the portfolio going to be rather than where it is today to the extent that individuals are kind of spending down what they've earned over their lifetime.

I think other investors that may struggle with private equity, there are ones that are uncomfortable taking on illiquidity risks. So private equity over time has had better results than, than publicly trade stocks and frankly, much, uh, more behaved performance during difficult parts of the stock market.

Like for example, in 2022, When stocks were down, let's call it 25% in the first nine months of that year, private equity firms were down maybe four to 5%. So, they did a lot better. So, with higher returns and lower volatility along the way, it can make a lot of sense to think about pivoting public equities to private equities, but the give up here really is that liquidity.

Once you invest in a private equity fund, we typically guide our clients that it takes about seven to nine years to get your money back, and then you won't see the profits come back between year 7 And 14. So, it is a longer time horizon. And for those clients that just aren't okay with having so much that they don't have access to, that's one area that we really want to make sure that they understand the reason why you should think about it at the end of the day is a very personal decision.

Stacie Jacobsen: Yeah. And then what about transparency concerns, right? There's some investors who just aren't comfortable in general because they don't know or feel that they understand exactly what they're investing in.

Wrug Ved: So, when you make a commitment to a private equity fund, you are really making a call on that manager or that group of managers that you're choosing to invest with and you know, you have no idea what your dollars are going to get invested in. You're basically writing them a blank check so that they can go out and find the best acquisition targets over the next three to five years. So that's the way private equity works. So, you'll have no transparency because you don't know is, are my funds going to buy a software company?

Are they going to buy, you know, a dermatology practice? Are they going to buy a quick service restaurant franchise? You are making a call that, do I think that the private equity businesses that are controlled by these private equity firms will outperform publicly traded stocks? And, you know, that's certainly been the case.

Um, in retrospect, we think it's going to be the case going forward, but you're right, that transparency that you often see in your stock market portfolio, you wouldn't necessarily have in a private equity investment.

Stacie Jacobsen: What are some of the final thoughts you'd like to leave them with?

Wrug Ved: Well, private equity sounds like perhaps a very exotic investment type, especially for those investors that haven't had the experience investing in private equity funds and seeing the benefit it can have for their wealth over time.

That private equity really is similar to what many people are used to, which is investing in publicly traded stocks, which is owning ownership stakes in great companies and private equity is the same thing you're enlisting managers to go out in their funds, to find great companies that have a good footing and relying on those private equity firms expertise to improve those businesses from within.

Stacie Jacobsen: All right. Well, with that Wrug, thank you so much for joining us today.

Wrug Ved: Thanks so much, Stacie.

Stacie Jacobsen: Thanks to everyone for listening in. If you want to learn more about private equity, I do want to recommend a recent Bernstein white paper written by both Wrug and Chris Brigham. We'll link it in the show notes.

Don't forget to like, share, and subscribe to The Pulse by Bernstein wherever you get your podcasts. I'm your host, Stacie Jacobsen. Wish you a great rest of the week.