Private Equity | Vanguard (2024)

Active manager search

John Pilkington: I think probably one of the most interesting conversations that was differentiating private equity from other alternative investments, one of the questions we will get occasionally is, "Is Vanguard going into hedge funds?" which is not the case here. And then as we kind of shift from some of the inexperienced investors to those that may be a bit more familiar with private equity in general, I think that reaction is dependent upon their experience in the past, whether it was a positive or a negative experience. And so, ultimately, I think in either scenario, we get to a point to where we are answering the question of why is Vanguard entering this space. And for some, it seems like it departs from the foundational nature of Vanguard's investment philosophy.

And so I'd like to ask you, given that you've been involved fundamentally from the get-go here with Vanguard's private equity, to maybe share a little bit more about the history of the search; also understanding a little bit more how this came to fruition.

Ariel Finegold: Absolutely. We love to answer this question. So Vanguard started over 45 years ago with our founding strategy as active management. And not a lot of people know this, but we started that way with the legendary Wellington fund as an active shop.

So we have a deep understanding over many decades of what drives active management. What are those drivers? What continues to make firms successful? And we have a team dedicated and focused not just at that level but at the highest level from our CEO to our Board of Managers on monitoring and making sure that active managers can continue to persist in their outperformance.

And so I give all that backdrop on our active story because folks don't always talk about that when it comes to Vanguard despite those great attributes and skills that we have in this space, and it's a good backdrop for this story of how we came to launch private equity at Vanguard.

So, you know, specifically for private equity, we had long studied the return enhancing and diversification benefits that private equity offers and our long-time philosophy of providing a market cap-weighted portfolio to our investors encouraged us to look at the growth of private equity relative to public equity. And by not including private equity in a client's portfolio, they were missing out on a growing swath of the equity market. And we saw this growth due to regulation, due to benefits that private companies were getting that made it more appealing to stay private for longer.

And so we understood all of these elements of the marketplace and, also, that due to the fees and the inefficiency and the opacity in this space, there's a very wide dispersion of returns between top private equity managers and underperforming private equity managers. And so if you picked the median private equity manager, it's likely that they're going to underperform in the public markets because of all of those elements in the space that I just touched on.

John Pilkington: Sure. Ariel, I think probably once we get to a fundamental understanding of private equity and we talk through the nature of the investment and the illiquidity, I think probably the best part that our clients start to latch onto as far as the benefits of this in their portfolio and the benefits of partnering with Vanguard to do it, it comes down to something that Vanguard has been a key driver in for many, many years, and that's a level of ease and simplicity. And so the ability to access a diversified product in a single allocation and having the ability to partner with an advisor or relationship manager to make that process for funding capital calls very easy, I think that's probably the biggest piece of that.

But I would be remiss if I didn't say that as we tell the story about private equity and we look at client portfolios and their objectives long term, the performance enhancement is part of what folks latch onto. So I think it's the ease of investing, it's the opportunity for performance enhancement relative to their public equity portfolios, and really between those two, I think that probably drives the majority of the conversations and, ultimately, gets us to a decision of whether it's right or wrong for our client portfolio.

Ariel Finegold: That makes perfect sense, and I think I should also mention before we enter any space or any asset class, we always ask ourselves, we have a very, very high bar and so we always ask ourselves, first, does the investment or the asset class have enduring investment merit? And then, secondly, can we be world-class in our offer? And so everything you just outlined makes perfect sense. How can I see this as a return enhancement? That return enhancement is very much predicated on, as I mentioned, those wide dispersion of returns consistent outperformance and consistent upper half, upper quartile access.

And so what we found is that in our search of the space and when we, ultimately, narrowed down to getting to our partnership with HarbourVest, what was so key is access that investors have a tough time getting on their own. And so what we've brought to the table, and many details about the offering will be available on the private equity resource website for folks to take a look at, is that this is a very diversified offering across strategy, across stage, across geography with a top performing private equity manager that can access funds that are often oversubscribed, meaning that there is too much demand and not enough supply. And they are disciplined and so they may be closed to new investors, and it's challenging to get access on your own.

And even if you have the right amount of assets and you could deploy in a diversified way, which is what is all included in this offer, it would still be really hard to get consistent top access to top managers. And that's what we've been able to bring using our scale and our size and our reputation to our investors so that they can achieve, as you just outlined, that return enhancement over the long term that private equity can bring if you partner with the right firms. And we've done that through our relationship with HarbourVest.

I think we have had some level of reputation at Vanguard at talking about low cost, but it's really what we are very interested in is net outcomes. And if costs come at a great premium where you're continuing to achieve outsized returns, it's very much worth it because they're well eclipsed by what you're achieving well above those costs. And that's what we've modeled and seen as we've looked at the private equity space and HarbourVest, in particular, and their consistent ability to achieve that top half, top quartile manager performance.

And so I wanted to spend another minute on that fees point because it will also feel and look a little bit different where you talked about the incentive alignment. We like when managers are achieving a certain incentive fee or carried interest. And so in this fund, it's going to be a little bit different than an expense ratio what you'll experience. And this is very typical in the private equity space is some kind of management fee that's administrative that helps keep the lights on. And we've been able to create an offering that's going to be very appealing we feel for our clients and when we look the across the industry, will be very appealing.

This communication does not constitute an offer to sell or the solicitation of an offer to buy any specific investment product sponsored by, or investment services provided by The Vanguard Group, Inc., Vanguard Advisers Inc., Vanguard Marketing Corporation, Vanguard National Trust Company, or their subsidiaries or affiliates. Investments in funds issued by HarbourVest are made available to the following Vanguard clients:

  • Self-directed clients of Vanguard’s Retail Investor Group can access HarbourVest funds through Vanguard Marketing Corporation. The decision to invest in the HarbourVest funds will be the sole responsibility of such self-directed clients, and no Vanguard entity will determine the suitability of investments in any HarbourVest fund or otherwise make investment recommendations to Vanguard’s self-directed clients.
  • Advised clients of Vanguard’s Personal Advisory Services can access HarbourVest funds through Vanguard National Trust Company. Vanguard National Trust Company will assess the suitability of any recommendations to PAS clients to invest in the HarbourVest funds.
  • Advised clients of Vanguard Institutional Advisory Services can access HarbourVest funds through Vanguard Advisers, Inc. Vanguard Advisers, Inc. will assess the suitability of any recommendations to its advised clients to invest in the HarbourVest funds.

Any such offers may be made only to Vanguard clients who met the definition of accredited investors and qualified purchasers under federal law and by means of delivery of a confidential Private Placement Memorandum or similar materials that contain a description of the material terms of such investment. No sale will be made in any jurisdiction in which the offer, solicitation, or sale is not authorized or to any person to whom it is unlawful to make the offer, solicitation, or sale. Private investments involve a high degree of risk and, therefore, should be undertaken only by prospective investors capable of evaluating and bearing the risks such an investment represents. Investors in private equity generally must meet certain minimum financial qualifications that may make it unsuitable for specific market participants.

All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.

With private equity (“PE”) investments, there are five primary risk considerations: market, asset liquidity, funding liquidity, valuation, and selection. Certain risks are believed to be compensated risks in the form of higher long-term expected returns, with the possible exceptions being valuation risk and selection risk. For selection risk, excess returns would be the potential compensation, however, limited partners (“LPs”) must perform robust diligence to identify and gain access to managers with the skill to outperform. PE investments are speculative in nature and may lose value.

Market risk: Private equity, as a form of equity capital, shares similar economic exposures as public equities. As such, investments in each can be expected to earn the equity risk premium, or compensation for assuming the nondiversifiable portion of equity risk. However, unlike public equity, private equity’s sensitivity to public markets is likely greatest during the late stages of the fund’s life because the level of equity markets around the time of portfolio company exits can negatively affect PE realizations. Though PE managers have the flexibility to potentially time portfolio company exits to complete transactions in more favorable market environments, there’s still the risk of capital loss from adverse financial conditions.

Asset liquidity risk: Various attributes can influence a security’s liquidity; specifically, the ability to buy and sell a security in a timely manner and at a fair price. Transaction costs, complexity, and the number of willing buyers and sellers are only a few examples of the factors that can affect liquidity. In the case of private equity, while secondary markets for PE fund interests exist and have matured, liquidity remains extremely limited and highly correlated with business conditions. LPs hoping to dispose of their fund interests early—especially during periods of market stress—are likely to do so at a discount.

Funding liquidity risk: The uncertainty of PE fund cash flows and the contractual obligation LPs have to meet their respective capital commitments—regardless of the market environment—make funding risk (also known as commitment risk) a key risk LPs must manage appropriately. LPs must be diligent about maintaining ample liquidity in other areas of the portfolio, or external sources, to meet capital calls upon request from the General Partners (“GPs”).

Valuation risk: Relative to public equity, where company share prices are published throughout the day and are determined by market transactions, private equity NAVs are reported quarterly, or less frequently, and reflect GP and/or third-party valuation provider estimates of portfolio fair value. Though the private equity industry has improved its practices for estimating the current value of portfolio holdings, reported NAVs likely differ from what would be the current “market price,” if holdings were transacted.

Selection risk: Whether making direct investments in private companies, PE funds, or outsourcing PE fund selection and portfolio construction to a third party, investors assume selection risk. This is because private equity doesn’t have an investable index, or rather a passive implementation option for investors to select as a means to gain broad private equity exposure. While there are measures an investor can take to limit risk, such as broad diversification and robust manager diligence, this idiosyncratic risk can’t be removed entirely or separated from other systematic drivers of return. Thus, in the absence of a passive alternative and significant performance dispersion, consistent access to top managers is essential for PE program success.

For qualified purchaser and accredited investor use only.

© 2022 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.

Private Equity | Vanguard (2024)
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