Posts in Equity Investing
The Changing Landscape of Private Equity: Pros and Cons

Written by Sloan Smith, CAIA, CPWA®
Sloan is a Vice President at Innovest Portfolio Solutions


The private equity investing environment has witnessed major changes in the last dozen years. Valuations, dry powder (i.e. unused capital), and fundraising all have increased to levels not seen since the years leading up to the Global Financial Crisis of 2008. From 2006 to 2007, the private equity asset class invested large amounts of capital at high asset prices, which led to lower returns in subsequent years. Some investors worry that we may be experiencing a similar situation today. However, it is important to take a deeper look at how the current private equity investment environment compares to that of a dozen years ago. An assessment of the advantages and disadvantages of the current environment will help investors to make prudent decisions for their long-term portfolios.

Advantages of the current private equity environment:

1. Less leverage

In 2008, the average U.S. private equity transaction was levered at 7.5x debt-to-earnings before income, taxes, depreciation and amortization (EBITDA).1 In 2018, the average private equity deal was levered at 6.2x Debt-to-EBITDA.2 Also, the ratio of debt to equity is more moderate today than ten years ago. In 2009 the average percentage of equity that private equity managers were committing to their deals reached a low of 30%, meaning they had a lot less skin in the game. Today, private equity firms are investing, on average, close to 50% of equity into their transactions, which is a significant improvement.3

2. Prudent and cautious investment process

Private equity investment activity is running at a significantly lower level than that of 2006 and 2007. Private equity deal volume was close to 40 percent lower in 2017 than its peak in 2007.4 Volume has been mainly from larger funds and their significant deal sizes. However, the greater private equity space has been cautious in a higher valuation environment and has been more thoughtful in identifying opportunities and investing capital.

3. Avoidance of club deals

A club deal is when numerous funds work together to make a large private equity transaction. In 2006 club deals made up more than 50% of private equity purchases that were greater than $1 billion.5 However, during the Global Financial Crisis of 2008, private equity managers were faced with joint control hindering prompt decision making, especially in the board room. The size of these deals also made it difficult to complete the transactions. Though club deals still exist, they recently represented only $50 billion of the aggregate private equity deal value, versus $300 billion in 2007.6 Currently, private equity firms tend to favor institutional limited partners eager to potentially co-invest on deals, or corporations providing some strategic value.

Disadvantages of the current private equity environment:

1. Valuations

In 2018 the median private equity EBITDA multiple was 11.1x .7 This multiple is the highest level in the last eleven years (see Chart 1). One reason for these expensive valuations is that private equity strategies value their deals based on valuations in the public markets, which have risen significantly since 2008. Additional reasons for the valuations are low interest rates and the cost of debt. Access to cheap financing has encouraged some private equity firms to make aggressive purchases at higher prices.

2. Dry Powder

Dry powder is the amount of capital that is sitting in cash or similar securities waiting to be invested by private equity managers. Private equity dry powder has grown, on average, about 20% a year since 2012, accumulating to $1.2 trillion as of mid-20188 (see Chart 2). This growth is due to heavy amounts of fundraising and investors becoming increasingly interested in private equity for its return potential.

3. Competition

Growing competition for private deals has been pushing up prices in private equity, particularly in competitive auctions. This trend may tempt private equity strategies to reduce their due diligence criteria in order to invest capital and keep up their pace of calling capital. Private equity firms are not paid large management and incentive fees to sit on the sidelines. Their limited partners expect them to allocate capital and could grow impatient if their committed dollars are not invested.

Over the past 15 years private equity has outperformed the S&P 500 by an average of 400 basis points per year.9 There are mixed reviews of today’s private equity environment and whether investment returns will be as strong in the future. Some investors are not only worried about valuations, but about the flood of capital is waiting to be invested. Others point to reduced deal volume and fewer club deals as positive indicators. It is essential that investors understand the asset class’s current environment when considering its merits for their long-term portfolios.

Think Twice about Equity Indexed Annuities

By Rich Todd, Managing Principal, CEO and Jared Martin, CFP®, AIF, Vice President

Equity-Indexed Annuities (EIAs) are complicated financial products with considerable disadvantages. However, EIAs are often sold by annuity salespeople who may be motivated by sizable commissions, rather than their client’s best interest.  It has become increasingly clear to us at Innovest that many people who have invested in these products will not receive what they expect.  In this article, we will review EIAs and how their earnings are calculated, explore the issues that arise from salesperson compensation, and examine a recent case study.

What is an Equity Index Annuity?

With an annuity, you exchange a certain amount of principal up front for payouts by an insurance company in retirement. The payouts for EIAs, sometimes called “index annuities”, are somewhat based on the performance of an equities index, like the S&P 500. If stock prices rise during a specific time period, EIA owners receive an interest rate based on the partial rise in stocks. If stocks fall, EIA owners earn a minimum interest rate. FINRA (the Financial Industry Regulatory Authority) describes EIAs as “having characteristics of both fixed and variable annuities. Their return varies more than a fixed annuity. EIAs offer a minimum guaranteed interest rate combined with an interest rate linked to a market index.”

How are earnings for EIAs calculated?

Earnings for EIAs are calculated somewhat differently than traditional annuities.  Generally, the insurance company that sells the EIA will declare an index participation rate—or a percentage of the index’s gain—that is promised to the annuity owner.  If the participation rate is 80%, the investor will be credited with 80% of the index return. Also, many EIAs have a maximum cap that limits how much gain can be received over a defined time period  Importantly, dividends are typically not included in the return calculation of the index. Dividends are a key component in total market return and help to reduce volatility.  The exclusion of dividends is a real cost to the investor.  The recent S&P 500 dividend rate is 2%. As Ethan Schwartz of The National states, “the S&P 500 isn’t’ travelling at full speed” when dividends are excluded.

The second component, like a fixed annuity, is the declared rate component. This rate is typically paid  on at least 87.5% of the investment and is usually a 1% to 3% interest rate.

The third component is the “spread” per cost, a deduction against the return, which typically ranges between 1.5% to 3.5%.

Here is the formula:

Index Returns (without dividends) + Declared Rate - Spread = Earnings

How are earnings taxed?

Earnings are deferred until distributed to the annuity owner. Distributions are taxable at ordinary income tax rates.  There is no tax advantage to owning an annuity in a retirement plan or an IRA.

What about the costs?

Spread – 1.5% to 3.5% per year

Dividend elimination – for the S&P 500, it was recently 2%

Surrender charges – if the annuity is sold within the first five to 10 years, the owner pays a charge of 4% to 10%

Salesperson Compensation
The salesperson earns a commission from the spread of the product, either front-loaded with a typical commission of 5% to 10% of investment. The higher the spread, the higher the commission to the salesperson– a significant conflict of interest.  Further, these salespeople are not legal fiduciaries.  Fiduciaries offer advice only in the best interest of their client, while non-fiduciaries do not have this obligation. In addition, the surrender charges are in place primarily to compensate the insurance company for the commission paid to the salesperson.

Two regulatory bodies – the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) -- have offered instructive notices on EIAs.  FINRA, predecessor of  NASD (The National Association of Securities Dealers), has noted:  “NASD is concerned about the way an associated person is marketing and selling unregulated EIAs, and the absence of adequate supervision of these sales practices.  For example, FINRA has heard the following claims:

  • ‘What if the market goes down and you would lose nothing? The market goes up, you gain!’

  • ‘A win/win Investment vehicle’

  • ‘How your retirement funds can have security of principal, higher than CD rates of interest, opportunity for growth (no losses)’

  • ‘Pick up where Social Security leaves off with new tax featured annuities…  featuring… two indexed accounts linked to a popular market index’

  • ‘If you’re looking for upside potential and no market downside, look no further than (name of EIA). This fixed annuity… enables you to make the most of S&P 500 index gains…’

  • ‘Growth potential without market risk’”

According to FINRA, investors are being misled by these sales tactics.

Case Study

A participant in a retirement plan recently took a lump sum distribution out of the plan to invest in an EIA instead of keeping her assets in the plan.  The total investment and recordkeeping costs in the retirement plan were less than 0.70%.  It was explained by the salesperson that there would be “no fees” in the EIA and that it offered protection that she did not have in the plan.

Here were the characteristics of the EIA sold to the participant:

  • Spread cost of 2.25%

  • Surrender charge starting at 9% for the first four years, then declining by 1% per year for the next five years

  • The declared rate was 1% on 90% of the investment

  • The future dividends of the index would not be included in the investor return

  • “The insurance company pays me,” the salesperson said.  On a $200,000 investment, the salesperson made either $14,000 up front or $2,000 per year for nine years ($18,000), paid directly from the investment.  The compensation came directly from the insurance company’s profits created with the annuity purchase.

Conclusion

The low returns of EIAs combined with high costs typically don’t make EIAs worth it.  By having a sound process for portfolio design and prudent asset allocation, downside risk can be reduced through much lower costs than EIAs.  At Innovest, we believe that most EIA purchasers have expectations of higher earnings than they receive because of the dividend elimination and high costs.  Further, annuities do not offer any tax advantages as compared to a traditional retirement plan—withdrawals from both are taxed at ordinary income rates. Assets invested outside of a retirement plan can help defer taxes through low-turnover investments, and eventually asset sales should be at a long-term capital gain rate, not ordinary income like an annuity or a retirement plan.

Salespeople prey on retirement plan participants looking for big sales with a “product that a retirement plan can’t offer.”  These participants are better off taking advantage of plan education services that lead to a sounder and much lower cost approach.


 References

1.      Notice to member.  NASD August 2005 Guidance.  Equity Indexed annuities.

2.      Investor Alert. FINRA Equity Indexed Annuities: A Complex Choice

Rebalancing

Routinely rebalancing a diversified investment portfolio plays an essential role in helping investors achieve their investment objectives. Instead of using a buy-and-hold strategy, Chris Meyer, Innovest Vice President, advises periodic rebalancing to ensure that a portfolio’s expected return and volatility characteristics stay on target. Click here to read the article on page 3.

Source: Innovest

Avoid Emotional Investment Decisions

Authors: Chris Meyer, Innovest Vice President and Abigail Thomas, Innovest Lead Senior Analyst

Imagine waking up on Saturday morning in early April of 2016, ready for a sip of coffee and a quick look at how your investments performed during the previous quarter. Your eyes land on Harbor Capital Appreciation, your large cap growth fund. The performance numbers catch your attention, but not in a good way. The fund was down 5.49% in the first quarter, while the benchmark, the S&P 500 Growth Index, was up 0.53%. Instead of essentially breaking even with a low-cost index fund, you paid active management fees and lost about 5.5%, in one quarter? Harbor Capital Appreciation seemed like a poor investment. Surely you could have been invested in something better. You decide that you are going to call your advisor and discuss replacement options.

Why Do I Think This Way?

You pause long enough to eat breakfast before making the call, which allows your emotion to subside a bit. Reflecting for a moment, you ask yourself: Why the immediate, emotional reaction to last quarter’s poor performance? Because you are human. Our decisions are often influenced by the subconscious biases that swirl around beneath our conscious reason. Some of those cognitive biases can help explain why it is so easy to make a snap judgment when confronted with an investment loss.

Paying Too Much Attention to Recent Pain

People tend to experience the emotional pain of negative events, including investment losses, twice as strongly as they experience positive emotions from good events, like investment gains. To state the principle conversely, a positive experience creates about half the amount of emotional impact as a negative one. Paired with human tendency to allow emotions to influence decisions, it’s a recipe for less-than-rational decisions.

These tendencies are a central feature of Kahneman and Tversky’s 1979 prospect theory, which argues that people derive utility, or satisfaction, from changes in wealth, rather than from absolute levels. A simple example illustrates the concept: A person given the choice between 1) receiving $20 and 2) receiving $40 then immediately losing $20, will typically choose the former. That is true even though each situation results in the person having $20; the loss involved in situation two makes it much less appealing.

Another obstacle to investing rationally stems from the human tendency to give more weight to events that occurred recently as compared to events in the more distant past. Despite many past quarters outperforming most large cap growth managers, Harbor Capital Appreciation’s recent performance had been poor, which could have resulted in our human brains judging the investment as an overall poor performer.

These recent, painful experiences are sometimes distracting from other highly relevant data points. Here, investors may have trouble seeing past recent poor performance despite understanding that performance is only one of many factors that should bear on selecting a mutual fund. After all, investors ought to give great weight to qualitative measures of investment process, style, and personnel, along with the fund’s historical performance.

What Happens if I Act on These Tendencies?

Typically, reacting to recent underperformance is a recipe for mediocre investment results. A 2008 study examined the behaviors of 3,400 retirement plan sponsors between 1994 and 2003, specifically focusing on 8,755 manager hiring decisions1. The study showed that fired managers tended to outperform their replacements during the three years after the change, even when their historical returns outpaced the fired manager over the previous three years.

What Should I Focus on Instead?

First, remember every fund will underperform for periods of time. The reasons can vary from market cycle, to the fund’s investment decisions taking time to play out, to the manager’s unique style simply being out of favor. Diversification—investing in several different asset classes— typically results in a mix of investments outperforming and underperforming in all market environments. This fund diversification normally lowers the portfolio’s volatility, reducing the shock that any one market factor can have on the portfolio.

Second, consider both quantitative and qualitative measures when monitoring an investment. At Innovest, we pay close attention to the fund’s investment style and strategy, the manager’s experience and credentials, and the overall organization structure and governance. When we score an investment highly in these categories, it means that we have conviction that the necessary pieces are in place for the investment manager to execute a thoughtful and proven strategy that will achieve the fund’s stated goals. Paired with the quantitative measures of the fund’s size, performance, and costs, these qualitative criteria provide a robust picture of an investment and its suitability for your portfolio.

So, when should performance be an issue? When the underperformance is inconsistent with the investment manager’s process or style, or is the result of a significant process or personnel change, an investor should closely examine the merits of changing managers.

Returning to our Harbor Capital Appreciation example, the underperformance relative to the index experienced in the first half of 2016 was not inconsistent with the established investment process, was not the result of a change to fund management and was not a problem warranting manager replacement. Changing funds would have been a mistake.

In fact, if you avoided the pitfalls described above and remained invested, you would have been rewarded with a total return of 22.77%, 2.27% in excess of the S&P 500 Growth Index return of 20.50%, for the period April 2016 through June 2017. Qualitatively, the same investment team has continued to employ the same investment strategy. This includes a willingness to significantly overweight sectors that the team expects to outperform.

To be clear, this example does not prove that every underperforming fund will have an incredible upswing in the following year. Nonetheless, we believe focusing on short-term performance can distract investors from more meaningful factors and lead to suboptimal investment decisions.

1 Goyal, Amit, and Sunial Wahal. “The Selection and Termination of Investment Management Firms by Plan Sponsors.” THE JOURNAL OF FINANCE, LXIII, no. 4, Aug. 2008, pp. 1805–1847.

Source: Innovest

Diversification Will Always Disappoint

"Viewed with the benefit of hindsight, diversification will always disappoint. To judge the outcome of diversification after the fog of uncertainty has lifted, however, misses the point: diversification provides us the incredibly important ability to admit we don’t know. We can be vaguely right instead of precisely wrong. Constant disappointment, then, might be the greatest indicator that we are well diversified." Click here to read more.

Source: Newfound Research

Fidelity: What if the Market is Revaluing Dividends?

Investors seeking current income have been forced to move out the risk spectrum within the fixed income universe, pushing nominal yields of nearly all instruments close to 50-year lows. The parallel to this behavior within the equity universe appears to be causing a phase change in terms of desired equity characteristics. Investors are increasingly favoring companies with high current yields and payout ratios. To explain this paradigm shift, we will present a unified valuation framework for both dividends and undistributed earnings which attempts to reconcile these phenomena.

Please click here to continue reading Fidelity's take on dividend paying equities.