Should John Q. Public Invest in the Carlyle Group?
(Corrects details of relationship between Central Park Group and Carlyle Group in second and fifth paragraphs of post published March 19.)
Someday soon, you -- accredited investor with $200,000 in income ($300,000 for a couple) and $1 million in assets besides your primary residence -- may be able to buy into a secretive pool of capital that will be put to work taking companies private and reaping the profits when they are taken public again. And you will only need to pony up $50,000.
Central Park Group, a money manger that works with high-net worth individuals and small institutional investors, filed documents with the Securities and Exchange Commission detailing plans to raise a $300 million fund that would then invest in funds raised and managed by the Carlyle Group, the Washington-based private-equity firm. The minimum investment for the fund would be only $50,000. This represents a sea change for the private-equity industry, which until now was only open to people who could make much bigger minimum investments (in the neighborhood of $5 million to $20 million) or giant pools of savings, such as endowments and pension funds.
And it raises a question: While the chieftains of private equity have done quite well for themselves, is it really something for the mass-affluent investor?
Reading the filing, the one thing that comes out buried in legalese and investment talk is the fees. Fees on top of fees on top of fees. While a typical private-equity fund has a management fee of 1 percent to 2 percent -- paid irrespective of performance -- and then 20 percent of the profits after a certain level of returns are paid out to the investors, the new Carlyle fund layers more and more on top.
The fund charges a 3.5 percent sales load on the initial investment and then annual fees estimated at 3.68 percent. And this is before the carried interest Carlyle gets on the actual returns to their funds’ investments. And if the fund invests some of its assets in a fund of funds (one that invests in a number of other private-equity funds), investors could expect to face more fees. As the SEC filing puts it: “To the extent that the Fund invests in an Investment Fund that is itself a 'fund of funds,' the Fund will bear a third layer of fees.” This is fee-charging as imagined by the director Christopher Nolan in the film “Inception.”
But what are investors getting? Access to Carlyle’s current and future funds. Although Carlyle does other types of investing, it is still primarily a buyout shop. Such buyouts produced far higher returns than the Standard & Poor's 500 Index from the 1980s until the financial crisis, according to recent comprehensive research by Robert S. Harris, Tim Jenkinson and Steven N. Kaplan of the University of Chicago's Booth School of Business. Since then, however, private equity has fallen off a cliff while the boring old S&P 500 has been on a tear.
This should be a concern for investors in Carlyle’s new fund. In the SEC filing, Carlyle says a portion of the fund’s assets may be invested in “secondaries,” meaning funds that have completed fundraising and are invested in assets that already generate income. The rationale is to alleviate the “J curve” in private-equity investing, where funds' net asset values decline in the first few years as they charge fees and make investments that don’t produce returns until later.
One worry for retail investors is that their money might be put into precisely those funds raised during the fat years that are due for thin returns. While Carlyle’s funds as a whole have had high internal rates of return, not all of them do: Three of its more recent buyout funds, started in 2006 and 2008, respectively, have so far had negative net internal rates of return. (To be sure, private-equity fund performance is best measured over a longer period of time, closer to 10 years.)
While it’s easy for the retail investor to get exposure to and data on U.S. equities through a low-fee mutual fund, very few investors are actually exposed to private equity as an asset class –- only gargantuan pension funds such as the California Public Employees’ Retirement System, which has invested more than $1 trillion in more than 800 funds, can really claim to be. And even Calpers can’t get perfect data from the firms it invests with.
A paper by Tim Jenkinson, Miguel Sousa and Ruediger Stucke found that firms tend to report higher valuations for their funds to Calpers when they are raising money for “follow-on” investments in their existing funds than the fund’s ultimate net internal rate of return or during other periods. They write that “investors should be extremely wary of basing investment decisions on the returns of the current fund, especially when looking at reported IRRs” and that the internal rate of return of current funds, though the standard metric for fund performance, is not the best barometer for predicting actual returns to investors.
If even Calpers is having trouble getting the best data from the firms it invests in, it’s hard to imagine how the average retail investor would do any better. And Carlyle’s foray into the accredited-investor class won’t be its last. According to the Wall Street Journal, Carlyle thinks there is $10 trillion worth of wealth out there to be tapped by private-equity firms in the accredited-investor class.
David M. Rubenstein, Carlyle’s co-founder, also has his sights set on 401(k) plans. He told Bloomberg Radio in an interview, “I think it will be possible in the future where 401(k) check-off plans will be able to say you can take a certain amount of your money a year and go into an illiquid private-equity fund.” Fortune magazine’s Dan Primack reported last week that a private-equity adviser is working on a product to let participants' defined-contribution plan invest in private equity even if they fall below the accredited-investor threshold. There is more than $3 trillion saved in Americans’ 401(k) plans.
And what’s the SEC doing in response to highly risky, illiquid funds going farther down the investor totem-pole? Well, building on measures in the 2012 JOBS act intended to make it easier for firms to raise capital, the commission has proposed rules to allow direct advertising of investments in hedge funds, private equity and venture capital. Although the rules aren't final, soon Carlyle won’t have to leak its plans to the Wall Street Journal to let investors know what opportunities await. And shops with far fewer scruples, less distinguished records, and even higher fees than Carlyle will probably jump into advertising most aggressively, offering riches previously only available to the megarich. Let the buyer beware.
(Matthew Zeitlin is a contributor to the Ticker. Follow him on Twitter.)