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Rekenthaler Report

The Cons (and Pros) of Vanguard’s Decision to Offer Private Equity

The timing is suspect, but the concept may eventually make sense.

Strange Days Indeed
I confess to being puzzled by Vanguard’s news that it has partnered with a private equity investment firm, HarbourVest.

Of all possible Vanguard additions, private equity seemed to be about the least likely. Vanguard serves mostly retail clients, with publicly traded securities, in liquid funds that carry very low expense ratios. In contrast, private equity investments are largely institutional, aren’t traded, and are owned by illiquid funds that are notably expensive. The fit, to put the matter gently, is not obvious.

The timing is also perplexing. Vanguard is not known for entering “hot” markets. The company did not launch tactical-allocation funds following the 1987 stock crash, nor a technology fund during the New Era, nor alternatives funds 10 years back. In fact, Vanguard has frequently flouted the investment trends by temporarily closing the doors to its best-selling funds. Overall, its actions have been counter-cyclical.

Not this one. Per PitchBook’s 2019 report (note: PitchBook is a Morningstar subsidiary), private equity investing is reaping record sales. Last year, the marketplace attracted $301 billion in new assets. That was its highest amount ever, exceeding the previous record of $267 billion, which was set in 2007. If that timing concerns you, it should. Historically, private equity has attracted the most capital at the worst times to invest, and the least capital at the best times.

In its 2019 report on private equity, Bain & Company didn’t mince words. “For general partners [of private equity funds], putting record amounts of capital to work means getting comfortable with a certain level of discomfort when investing. They are paying prices they swore they would never pay and looking to capture value that may prove elusive.”

Performance-Chasing
Meanwhile, flows into global hedge funds have been roughly flat, down significantly from the previous decade. The reason for the discrepancy in sales between the two varieties of investment is depressingly simple. Private equity funds are more aggressive than hedge funds, and thus have been that much better suited to ride the 11-year stock bull market. They are in favor because they have performed relatively well, and they have performed relatively well because their style has been in favor.

That is a contrarian investment sign, as are the efforts by some private equity firms to abolish the rules that prevent them from selling into 401(k) plans. Nobody would heed a similar request from hedge fund chiefs. Two leading private equity executives recently made a presentation to an SEC advisory commission--which includes a Morningstar employee as a member--because (it seems) their funds have benefited from the great bull market.

Has Vanguard conceded to fashion by offering what sells today, rather than what will benefit shareholders tomorrow? One certainly could interpret its press release that way, particularly as Vanguard touts its forthcoming funds as being an “incredible opportunity” for “individual investors.” Those words had me holding my wallet.

The Bright Side?
That said, Vanguard has spent 45 years doing the right thing for its shareholders. It may have done this time as well. After my initial critique, I took the opposite approach of attempting to think if this private equity effort could be successful, and if so how. I decided in the affirmative, with two stipulations:  

1)     Begin only with institutions.

Vanguard’s main occupation is managing funds for individuals (sometimes directly, sometimes through financial advisors). But quietly, it has built a business serving small to midsize pension/endowment funds. Such funds are increasingly emulating their larger funds, by holding fewer conventional stocks and bonds, and more alternative investments--especially private equity.

We can question whether this approach is ill-timed (as I just did), but I do not think that Vanguard should be chastised for selling private equity funds into this marketplace to meet its customers’ demands. After all, these clients are institutions. They are fully accountable for their asset-allocation choices. (Vanguard also serves as an outsourced chief investment officer for some institutions, which is a different arrangement, but I think that a similar logic applies.)

In contrast, bringing an asset class to individual investors is implicitly a recommendation. Fund companies quite properly are criticized for creating gimmick investments (for example, 130/30 funds), or for mistiming their launches by selling high, thereby encouraging their shareholders to chase trends. It would be imprudent for Vanguard to rush private equity funds to individual buyers.  

Happily, that is not what the company is doing. Vanguard has stated that it will initially sell its private equity funds to institutions only.

2)     Revolutionize the pricing.

Throughout this column, I have described Vanguard’s future offerings as “private equity funds,” but that was shorthand. Actually, they will be private equity funds of funds, because that's what HarbourVest does. It assembles portfolios of private equity funds, which are diversified not only in number, but also by type, as they include venture-capital, leveraged-buyout, and debt funds.

This implies two levels of fees. The partnership of Vanguard/HarbourVest will levy an explicit fee for the duty of assembling the underlying funds. Meanwhile, the underlying funds will charge their own management fees, which are implicit from the viewpoint of the Vanguard fund-of-funds shareholders.

The Vanguard/HarbourVest duo has full control over its explicit fee, which presumably will be low by private equity fund-of-funds standards. (Vanguard isn’t discussing the topic.) The real question, though, is whether the partnership can negotiate lower rates for its underlying funds, which are pricey indeed, typically carrying a 2% annual expense ratio, plus a performance fee that gives management a cut of the profits. No matter what Vanguard charges for its fund-of-funds won’t be cheap unless it can lower its vendor’s pricing.

Whether this can be accomplished, we shall see. That topic lies well beyond the scope of this column. It’s worth noting, though, that large fund-of-funds managers such as HarbourVest are already using a process called “co-investing” to reduce their underlying costs, and that Vanguard historically has demanded--and received--substantial volume discounts. So, perhaps this admittedly ambitious goal can be accomplished.

This version of the article contains clarification about the presentation to the SEC advisory commission.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.