Which Private Equity ETFs can get us a piece of PE?

Part two of our series on getting exposure to private equity firms.

Aug 18, 2024

Welcome to part two of MarketScouts' Private Equity series!

Previously, I discussed PE-backed IPOs as one of our options for getting exposure to private equity indirectly. This time we’ll look at investing in publicly listed PE firms and see if we can get exposure to PE a bit more directly.

Some of the questions I’ll try to answer: What factors drive PE firms' earnings, and how are they affected by macroeconomic factors and geopolitical tensions? What are firms doing to mitigate adverse effects? And are PE firms a good deal now?

Why PE firms?

Private equity funds have historically outperformed the S&P 500 over the long term.1 This outperformance is attributed to PE's ability to generate compelling returns by actively managing and restructuring portfolio companies.

A study called "How Alternative Are Private Markets?" by Goetzmann, Gourier, and Phalippou, found that private market funds capture unique risk premia not seen in public markets. The study develops eight factors explaining 60% of private market return variations, offering diversification benefits and potentially enhancing investor returns. In short, private markets provide significant investment opportunities beyond those in public markets.2

However, things have changed quite a bit in the past two years.

What’s the situation for PE firms now?

Let’s address the elephant in the room: interest rates.

Since the financial crisis, when central banks lowered interest rates to zero, borrowing money became incredibly cheap. This has increased the amount of deployable capital (“dry powder”) to astronomical levels:3

However, with the recent steep rise in interest rates, the private equity industry has found itself in a bind.

Investors, including significant sovereign wealth funds, pension funds, and endowments, are now holding their money (or, as PE likes to call it, “dry powder”) back before committing to further investments.

Overall, dealmaking, exits, and fundraising activities have sharply declined.4

This has led to liquidity issues, with limited partners (LPs) pulling back from new investments. Many firms have sharply cut debt – KKR, for example, has decreased debt from 60% in 2013 to 35% in 2024 to offset the effects of rising interest rates.

There are signs that things are improving, though, and deal activity is starting to pick up again – even if there are still plenty of valuation disagreements between buyers and sellers.5

It’s also worth noting that today's interest rates, while seen as "high," are below the historical average since 1976, presenting an opportunity to buy assets at lower prices.

To top things off, the Bank of Japan's recent rate hike from 0.1% to 0.25% – the largest since 2007 – has sharply impacted the carry trade, leading to yen appreciation and increased repayment costs for yen-denominated loans.PE firms, reliant on leverage, now face higher borrowing costs and tighter credit due to reduced foreign lending by Japanese banks, complicating deal financing and showing just how interconnected the global financial markets are.

Nonetheless, PE has gotten creative, investigating new opportunities and diversifying their portfolios from traditional private equity to include more infrastructure, real estate, and private credit. Although these investments are still affected by interest rate changes, the diversification can allow earnings to grow even in bad market conditions. These asset classes have different risk and return profiles, which can help stabilize returns in a volatile interest rate environment.

Let’s go through these one by one.

Real estate

Private equity buying out homes is one of the main reasons why PE is so controversial. PE firms can also buy out multifamily apartments, office buildings, retail shopping centers, and industrial warehouses. There are hardly any PE firms with little or no residential RE in their portfolio.6

However, the assumption that real estate will always be a resilient hedge against inflation might end. Times are changing, and rental property investors, specifically the broader commercial real estate (CRE) market, are facing significant headwinds. High interest rates and rising costs are pressuring the commercial real estate market, while WFH trends reduce demand for office space. 7Slowed rental growth and rising vacancies are leading to lower income and property values.8

Meanwhile, in the banking sector, over $1 trillion in CRE loans are set to mature and pose risk to small and midsize banks with high concentrations of these loans. As a result, corporate managers are preparing for tight lending conditions and increased borrowing costs. According to Harvard Business Review, the depth and duration of this CRE market crisis may extend over a decade, with long-term impact on property values and bank stability.9

That doesn’t mean that PE firms are not adjusting.

Take Blackstone. Blackstone's large (and often controversial) RE division is now highly selective, focusing on distressed investing. They see low real estate values as a chance to plant seeds for future returns. However, with a prolonged downturn and delayed Federal Reserve rate cuts, Blackstone is concerned they may not get to harvest returns soon. Blackstone invested only $25 billion in Q1 2024, a 21% decrease from Q4 2023.10

The extended high interest rate environment and market reactions to it "extends the investment window a bit for our $191B of dry powder," Gray (president and COO) stated. "It may slow some realizations and push them out a bit." However, they're not rushing to deploy it, recognizing that prolonged high rates may extend the investment window.11

Blackstone is still investing heavily. Its $3.5 billion acquisition of Tricon Residential made it a major U.S. landlord in cities like Atlanta, Dallas, and Phoenix. Blackstone also bought 1,750 rental homes from British builder Vistry for $740 million. Even in challenging times, Blackstone is still committed to expanding its global rental portfolio.

Another example is Brookfield Asset Management. They invest in logistics, office, and multifamily properties across North America and Europe, focusing on undervalued assets and developing platforms for markets like student housing and senior living. However, what differentiates their RE portfolio is that their strategy centers on more high-quality RE, unlike other private equity firms targeting lower-value assets. This focus helps ensure that the assets acquired are resilient and capable of generating stable, inflation-linked returns. For example, their global logistics business operates over 70 million square feet of logistics space with a 60 million square foot development pipeline worldwide. Also, they recently sold the famous 150 Champs Élysées in Paris.

Private credit

Private credit is a form of non-bank lending where private investors or firms provide loans to companies or individuals, often with customized terms and higher yields than traditional bank loans.

According to a 2021 report by global law firm Dechert, 45% of surveyed PE firms have increased their use of private credit financing for buyouts over the past three years.12 Private credit has created opportunities for private equity firms to provide alternative financing solutions. This includes direct lending and other non-bank financial services, which can offer higher yields than traditional fixed-income investments, driven by the flexibility and customizability of private credit, allowing PE firms to negotiate borrowing terms more effectively and execute deals faster than traditional bank financing.

One unique option PE firms negotiate with is Paid-in-Kind (PIK) loans. Paid-in-kind (PIK) loans allow borrowers to pay interest with additional debt rather than cash, typically deferring cash interest payments and increasing the principal balance owed.

PIK loans have surged in private credit due to rising interest rates, raising concerns. These loans increase debt over time, potentially overvaluing a firm's position and leading to risky debt loads. PIK loans can also distort financial metrics like EBITDA, misleading investors about profitability. While they ease short-term cash flow issues, they come with higher costs and risks, often leading to even larger financial burden when the debt matures.

Bridge loans have also become ubiquitous in PE transactions, with over 50% of PE funds using them to manage the timing gap between when funds are needed for acquisitions and when they are received from investors. Typically short-term with an initial maturity of one year or less, bridge loans are intended as temporary solutions until permanent financing, like high-yield bonds, can be secured.

Bridge loans incentivize quick refinancing to avoid high fees, offering PE firms the flexibility to execute deals quickly and delay capital calls, boosting internal rates of return. However, market volatility has made it harder to secure permanent financing, potentially extending loan terms and affecting financial metrics. The lack of transparency in bridge financing can lead to overvaluation, as investors may not fully understand the firm's debt obligations or the temporary nature of the financing.

Bond ladders

Speaking of short-term agreements, a bond ladder is an investment strategy that involves purchasing bonds with different maturities to create a steady income stream and reduce interest rate risk. Like bridge loans, bond ladders typically have shorter maturity rates, making them less sensitive to interest rates.

BlackRock is one of the PE firms that has basically embraced rising interest rates as a potential revenue source through its bond ladder products – its iShares iBonds ETFs. These short-term bonds are less sensitive to interest rate changes, making them less affected by rising rates compared to long-term bonds. In a bond ladder, the bonds mature more quickly, allowing investors to reinvest the principal at potentially higher prevailing rates. This flexibility can be advantageous when interest rates are expected to continue rising. It's a good move for BlackRock.

Retirement services

Other PE firms have found creative ways of getting access to capital without going to the market to refinance. One example is Apollo.

Apollo manages assets for public pensions, families, and institutions, focusing on returns for retirement services companies like Athene. The acquisition of Athene has been a key income source, with retirement services contributing to Apollo's growth amid high interest rates. In 2023, the division's spread-related earnings rose by 25.9% to $3.11 billion, driven by a higher net investment spread. Apollo's retirement services have been vital in supporting the company during high interest rates, with SRE growth and a 19% increase in earnings from Athene's capital. This division's higher management fees and gains have significantly contributed to Apollo's financial turnaround.13

How should we value PE firms?

PE firms certainly seems to perform well, even in uncertain times. But is this real?

They say that “it's hard to get someone to see the truth when their salary depends on ignoring it.” When PE firms invest in real estate (or anything, for that matter), they often aim for high returns while minimizing risks, using the internal rate of return (IRR) as an alternative performance number to attract investors. It is a metric that estimates the expected growth of an investment by considering all projected cash flows over its lifespan, helping to compare the profitability of different investments. IRR measures annualized returns over time but doesn't show the actual realized profit, so a high IRR doesn't always mean big gains, especially in short-term investments.

Because of this, PE fund performance is often overstated. Managers inflate IRR by using data from overvalued public peers, making the returns look better than they are. Because IRR isn't final until the assets are liquidated, PE firms report an interim IRR, mixing real and projected results. They can also manipulate the IRR by delaying the start of the calculation, boosting it artificially through tricks like using credit lines to postpone drawing down funds.

What should we do?

I can't specifically recommend individual PE firm shares, but I hope I have provided some insight into how PE firms have been mitigating the effects of high interest rates.

Some firms outperform the S&P 500, even in challenging times, but is investing in these companies the right move for us? As long as they keep price multiples high through private credit, real estate, bonds, loans, and service expansion, how do we identify a "good" time to invest in them?

Plus, not all PE firms perform well under every market condition. Each firm has different sector focuses, making them more or less susceptible to market changes. Many PE firms also use strategies beyond those mentioned in this article (including all that would exceed the word limit here).

Perhaps a better idea is to invest in an ETF that includes multiple PE firms. Here are some of the largest ones:

Invesco Global Listed Private Equity ETF (PSP);
ProShares Global Listed Private Equity ETF (PEX);
iShares Listed Private Equity ETF (IPRV.AS)l
and the VanEck BDC Income ETF (BIZD), which gives exposure to private equity investments through BDCs (business development companies).

A note on BDCs. Like private equity firms, BDCs – short for Business Development Companies – make debt and/or equity investments in mainly smaller, often struggling or growing businesses. Also, unlike most PE firms of the same size, BDCs are accessible to everyday investors because they are traded publicly, and they are required to distribute most of their income to shareholders. They also have some pretty decent tax advantages.

So, do we buy, sell, or hold these ETFs? A neutral way to compare them would be to look at their key metrics:

Sharpe ratio: which basically says “how much return you’re getting for one more unit of volatility?”
Historical volatility: which tells us how large the ups and downs have been for each ETF
How many holdings they have;
And how much they charge in fees.

Source: TradingView, ETFDB, Invesco, iShares, Yahoo Finance

The choice seems to depend on what kind of investor you are:

Do you want maximum return for the risk you’re taking? IPRV has the highest Sharpe ratio.
Do you want lower volatility and can’t stomach large drawdowns? BIZD fits the bill.
Do you want to be as diversified as possible while owning as many PE firms as you can? PEX has almost 100 PE firms in its portfolio.
Are you a Boglehead who believes in passive investing and want to reduce how much you pay in fees? PEX fits the bill again, with an expense fee comparable with what you’d pay for an ETF tracking the S&P 500.

Overall, though, while these ETFs have strong potential, the unpredictable nature of interest rates and economic shifts means that you should remain cautious. Sudden monetary policy or economic changes could lead to significant short-term losses. Balancing your portfolio with less volatile assets or keeping a close eye on economic indicators will be crucial in the months ahead if you want to manage these risks effectively.

What do you think?

MarketScouts