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Why Private Equity Is Ripe for Vanguard-Style Disruption

The shrinking number of public companies and high fees in private markets are the perfect conditions for a passive player to upend private equity, says Willis Towers Watson.

With public markets continuing to shrink globally, it may be time for a disruptor to come in and offer investors an alternative to private equity funds that charge 7 percent in fees, according to Willis Towers Watson’s investment think tank.

“The economy has undeniably shifted to companies staying private longer,” said Liang Yin, senior investment consultant at WTW’s Thinking Ahead Institute, in an interview. “My argument here is that the current play book for investing in private companies — primarily through high-cost private equity funds right now — needs rethinking.”

In the group’s new paper released on Monday, Yin argued that the current model of private equity — which essentially involves putting leverage on a company, improving it operationally, and then selling it in a short period of time — has reached the end of its useful life. He pointed to multiple studies which have shown that private equity funds charge total fees as high as 7 percent, which include management and incentive fees in addition to multiple costs charged back to the fund for normal investment activities like evaluating and doing due diligence on potential portfolio companies. A private equity firm needs to take extraordinary steps of squeezing out costs and using borrowed money to have any hope of generating returns above the fees, Yin said. 

But only a small subset of companies in the private markets are good targets and can withstand the pressure of those bold moves, he said.

“You need to find businesses with enough potential for turnaround and enough space for the financial engineering and you need to realize those returns in five to seven years,” he said.

The private equity industry now stands at about $3 trillion in assets. According to the Willis Towers Watson paper, however, there are $100 trillion in global unlisted companies.

Willis Towers Watson’s paper comes at a time when more companies are delisting and fewer are going public to raise capital. The trend has raised issues of fairness to individual investors, who can’t meet minimums required to invest in the private equity or venture capital funds that are the primary avenues to private markets. Shrinking public markets have also raised concerns about high fees for alternatives funds, just as fees are falling dramatically for both active and passive public equity and fixed income funds.

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Yin said there are plenty of other simpler, “passive-like” approaches to investing in private companies to consider, including models that don’t use leverage. Leverage can be risky and amplify investors’ losses during  economic downturns or times of other cyclical pressures — but it’s necessary to make the returns that private equity firms promise investors.

Yin said Warren Buffett’s style of investing is a passive style that investors could use to hold private companies. Buffett famously invests for the long term and doesn’t always change a company’s management team. Yin argued that investing in private businesses doesn’t have to be any different from investing in public companies, which are often held for many years without investors pushing for changes to the business’s strategy. With a Buffett-style private equity model, asset managers could charge significantly lower fees and reduce the need to make disruptive changes at the corporate level to generate returns. In fact, some of the largest private equity firms have recently launched funds that use this approach. 

According to Willis Towers Watson, part of the reason companies are staying private longer is because of short-term pressures in the public markets. But Yin points out that private equity investors can also exit investments after short periods of time. A new, longer-term private model could be appealing to a new segment of entrepreneurs and company founders.

There are other alternative private equity models as well. Some quantitative managers have developed ways to replicate private equity return streams by holding public stocks. These strategies offer transparency, consistency, and dramatically reduced fees.

Yin said that it’s increasingly popular for institutions to co-invest alongside private equity firms and hedge funds, as well as invest in businesses directly. But he cautioned that these approaches require massive changes as well as scale that are only realistic for very large players.

Willis Towers Watson suggested that “if the governance and human capital problems are too difficult for a single asset owner to overcome, perhaps this could be achieved by forming a platform where asset owners can collectively keep the private equity talent busy and reasonably rewarded and where investment ideas can be shared and co-created.”

At any rate, Yin argued that new ideas for passive private equity won’t come from the industry, which has been experiencing record profits. 

“Passive has disrupted the public space, I don't see why it couldn’t disrupt the private space as well,” he said. “They're both equity, just in a different form.”

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