Investing in Private Equity with Michael Bell

[00:05:07] Dean Barber: Yes.

[00:04:03] Michael Bell: So, you’re right, Dean. We are kind of at this interesting inflection point with some new emerging asset classes, and most of those emerging asset classes are in the private markets. Those private markets really consume a number of different asset classes, from private real estate to private credit to private infrastructure, and as you referenced private equity. Now, the private equity market and most of those private markets have been largely inaccessible to traditional investors.

[00:04:44] Dean Barber: Your ultra-high net worth people would get it. Your ultra-high net worth people would get it

[00:04:49] Michael Bell: If you have a high net worth, ultra-high net worth and really, it was primarily focused on the institutional investors so pension plans, foundations, sovereign wealth funds and the like have had access to private equity and private market vehicles for the last 30 or 40 years. It’s now just starting to proliferate downstream, kind of into ultra-high net worth, high net worth, the millionaire next door, for example, due to the new structures that are available.

But to give you a perspective of what private equity is, it’s really quite simple. It seems to be fairly opaque, and there’s not a lot of understanding because it really hasn’t been accessible to anybody and so individuals generally haven’t spent a lot of time with it. But private equity, okay, is just the investment in private companies. And that is really no different than investing into a public company, except a public company is listed on a stock exchange. It has a ticker symbol and you can invest in it that way. But many of the private companies that you can invest in, they are generally invested in by a big fund and you get access to that fund.

But many of the names, for example, of private equity firms, Cole Haan, Haagen-Dazs, Toblerone chocolates, these are all private companies. You hear the name, and it may sound like a middle-market public company that you’ve heard of, you’re very familiar with, but it’s not public. It hasn’t gone to the public registration process. It doesn’t incur the costs to go public and do an IPO, for example. It’s operating very similar to a public company, except it’s privately owned.

[00:07:02] Dean Barber: Okay. Let me just back up here because I see a couple of things that I think people really need to think about here. Number one, when you talk about who has been the historical investor in private equity and you say pension funds, endowments, sovereign nations, those types of things, one thing comes to my mind with those types of investors that is not synonymous with the investor in the market today, and that word is patience.

And understanding that when they are buying something, they’re not looking at this to say what it’s going to do in the next two weeks, three weeks, five weeks. They’re not checking the ticker symbol on a regular basis. They’re looking at this as a value built over a period of time.

And so, I think there’s a big distinction there between what the normal psyche of the individual investor is today, especially in a world of the Reddit-type things that are going on, and this is not that. This is something that is designed to build long-term wealth. And so, I think that’s really important for people to understand. So, and then the other piece of it is if these private companies are selling or you’re investing in these private companies, I guess a couple of questions. Number one, why would they do it? And number two, how much control do they give up when they sell to a private equity or investor like that? How does that all work?

[00:08:30] Michael Bell: Great, great questions. I’ll give you some perspective on that. So, why would a private company, how do they get financed, and why do they go the private route rather than the public route? Well, let me just kind of put this in context for everybody. Over the last 25 years, the number of public companies in the U.S. market has been cut in half. Twenty-five years ago, we had about 8,000 publicly listed companies.

Today, we have just over 4,000 publicly listed companies. And the reason for that is a lot of the regulation that has been brought to bear to be a public company. Sarbanes-Oxley is something that you’ve heard of it in the past, and to adhere to the Sarbanes-Oxley rules and regulations, there are some estimates out there that it may cost a company anywhere from $5 million to $7 million a year that could otherwise be net income to a company that they have to spend to be a public company.

There are also kind of quarter-to-quarter reports and reporting obligations that public companies have, and investors are a little bit fickle that if a public company misses an earnings report by $0.02 a share, then the stock may drop by 3%, 4%, or 5%. Really, in that company when you really think about it, nothing has really changed with that company from yesterday to today, except it’s worth 5% less. So, that variability and that investor behavior and the overall costs of being a public company drive a lot of companies away from that.

[00:10:30] Michael Bell: So, what are there other options? In private equity, the private equity business has grown massively over the last 25 years. It is now a $4 trillion industry. $4 trillion have been pumped in to private companies from sovereign wealth funds, from big foundations and endowments, ultra-high net worth individuals, family offices, for example, and they are now funding these private companies.

In a middle-market private company, when they have the choice of, “Do I want to go through the quarter-by-quarter-by-quarter scrutiny and all the additional costs and regulations of being a public company or do I want to be over here and be a partner with a private equity firm?” so many more companies are taking that option because they give up no additional control in that. Because when you think of a private equity firm, a private equity firm is attracted to a private company because of the success it’s had. And they’ve seen that success over the last three, four, or five, 10 years, and they want to invest in that success and enjoy that success with that private company.

So, traditionally, private equity firms, they may buy that company. They may buy 100% of that company, but they want the management team to do what they’ve been doing, the exact same thing that they’ve been doing it since inception because that’s what’s generated so much growth. And so, they generally don’t put any constraints on a company, and they try to help that company to the extent they can provide guidance and support and relationships to that company because they’re now an investor and they want it to grow even faster. And so, whatever they could do to support that private company, they will do it.

[00:12:31] Dean Barber: So, how then, Michael, how are these private equity companies or these private companies, how are they valued? How often do they get valued? Because I know it’s not like a ticker symbol that you can look up because it’s not publicly traded. So, how does one assess the underlying value or the health of the private companies if they choose to invest in private equity?

[00:12:52] Michael Bell: So, those companies are generally valued by the fund that invests in them on a periodic basis. Sometimes it may be monthly. More often it’s quarterly. And what normally happens is those private companies, some of them are quite large but private companies, and they have the traditional financial reporting that public companies do but it’s just not published. They do it internally.

And so, they do have their weekly financial reports and monthly financial reports and quarterly financial reports. And the private equity investor can look at those reports and see if they’re on track and they will revalue that company every month or every quarter based on the financial information they get and whether that company is on track, hitting its budget. The best way, Dean, that I can kind of describe it, think of a private company in the valuation of a private company like your house. So, you have this big asset and you sell a house today for $500,000. Tomorrow is that big asset, it’s privately held, is it going to be valued any differently tomorrow?

[00:14:20] Dean Barber: No.

[00:14:20] Michael Bell: Probably not. You know, next week is it going to be valued differently? Probably not. Next month? Maybe a little bit. In three months? You know, you may see a little bit of a change, but it’s a big asset and it doesn’t change day-to-day. And so, generally, the private equity firms look at the valuation on a monthly and quarterly basis.

[00:14:43] Dean Barber: Would it be fair, Michael, to make a comparison to an individual who may own a group of warehouses? Maybe they own some office buildings, or maybe they have an apartment complex or something like that and they’re looking at that. There’s no valuation done on that real estate on a daily basis. What you’re really looking for is free cash flow, right? Am I rented? Are things going up in value? Because you’re not buying and selling that real estate on a daily basis. And so, would that be similar to like a publicly-traded real estate fund versus private real estate? Are we thinking about the same thing there?

[00:15:19] Michael Bell: Yeah. Perfect analogy on that, Dean. And so, one of the things that you look at when you are doing valuations, intra-period. In every month or every quarter kind of intra-period there, you look at extraordinary events. Now, if the warehouse that you’re talking about or the apartment building, if it had a fire or a damage, if there’s something extraordinary happened to that asset, yes, you would kind of look at it and it would have an opportunity to revalue that.

Same thing with a private company. If there was something extraordinary that happened to the private company, it got a brand new contract with the government or it lost a big contract or one of the key executives left or something like that, that may cause someone to deep dive down a little bit deeper and revalue that asset. But your analogy is a perfect example.

[00:16:16] Dean Barber: So, let’s talk about the effects of public policy on private equity as opposed to the effects of public policy on public equity, i.e., let’s talk about the Federal Reserve and let’s talk about the easy money policy. Let’s talk about the bond-buying programs, the ultra-low interest rates, inflation. How do those different pieces affect the private companies different than the publicly traded companies?

[00:16:45] Michael Bell: So, I don’t know that that affects private companies any differently, but what you do see at the end of the day, so those policies generally affect businesses but whether it’s kind of an interest rate policy or kind of a new spending policy from the government, what you will see at a public company is you may see an immediate knee-jerk reaction from an investor’s perspective that changes dramatically the value of that company today, tomorrow, or whenever that new policy may be announced by the government or something like that. In private companies, there is a lot less volatility in the valuation of those companies because you don’t see that knee-jerk reaction.

You don’t get a new valuation as you said on commercial real estate or warehouse real estate or you get a new valuation on your house tomorrow because something came out in the press today.

So, you don’t have that behavioral finance tendency to create a lot of volatility in the market for private companies. So, the prices of private companies are a lot less volatile than publicly held companies. And so, therefore, those assets are not really correlated as much with public companies. And so, when public companies move up and down on a daily basis, these assets are much more slow and steady in terms of what you see and how they react to public policies.

[00:18:39] Dean Barber: Right. I think of this in a way that I think about it in simple terms, Michael, is an asset is worth what somebody is willing to pay for it. And if its value did anything other than what somebody is willing to pay for it, it’s not real. And so, we can look at companies today that are publicly traded that might be trading. You know, I see some of them at a thousand times earnings like Tesla, for an example, which is just outrageous, right? And then you look at the broad-based markets that a fair price-to-earnings ratio on a broad-based market is a 15 to 16 times earnings.

But then you get up into these periods where price-earnings ratios on publicly traded companies are up in the mid-20s. So, can you give us an idea from private companies to public companies. Are they valued the same way based on a price to earnings? Do they attach something similar to the private companies as the public companies as a price-to-earnings ratio? They look at a cash flow, price-to-book. How does that all work out?

[00:19:38] Michael Bell: It’s generally the same valuation methodology from a cash flow and enterprise value perspective. But what you do see there is, again, if it’s driven by the volatility, the price-to-earnings, the valuation of public companies is about seven turns higher than private companies, and there’s a much more of moderation in valuation and the fluctuation of values in private companies, as I said previously.

So, you may look at the S&P and the valuation there is kind of inflation 21, 22, or whatever gauge you look at, maybe even a bit higher than that. Wherein private companies, similar sectors, similar industry kind of across the board, you may be at a 15 or 16 times earnings and you don’t get the same frothiness in private markets that you traditionally see in some public markets, and we’re seeing today in a number of…

[00:20:47] Dean Barber: So, would it be fair to say it’s more difficult for the private equity market to get extremely overvalued because you have more intelligent investors that are really looking at the underlying fundamentals of a company and what they’re really willing to pay for it and what’s it really worth? Would that be a fair way to look at that?

[00:21:06] Michael Bell: So, I think you’re right down kind of the middle of the fairway on that one, Dean. What you’re seeing is on the private side, realize that they’re more intelligent investors, but you have professional investors. You have a team of professional investors that are looking at a company and they are valuing that company where a lot of the times in the public markets that valuation is based on maybe just retail behavior.

And what may be up on Reddit or what you’re hearing kind of in the press and that is really driving valuation, not the underlying fundamentals, whereas the professional investor, those private equity firms that are looking at doing diligence on those firms, they’re not really led astray by emotional behavior. It’s really kind of hard-core analysis that they are looking at to value those companies.

[00:22:01] Dean Barber: All right. Perfect. So, let’s talk about regulatory headwinds or tailwinds as they may be for the private markets. And where are we at today on that? Are there headwinds against private equity and regulation or do we have tailwinds?

[00:22:19] Michael Bell: Well, as I started out, I believe that we are in the start of a megatrend shift into private markets, opening up private markets to a much broader investor set. Okay. And when you typically see something like that, that type of movement, there’s typically a lot of regulatory headwinds, and because the regulators want to make sure that they have a handle on this new asset class and individual investors are not going to get taken advantage of or something like that.

And a good example is cryptocurrency, right? It’s kind of hot right now and the regulators are having a lot of discussions in Washington from the SEC to Congress about how do we regulate this? What type of regulations do we put in place? How do we protect investors?

Well, in the private markets, because of what you just mentioned, you have professional investors that are overseeing these assets and you have professional diligence that’s happening and you have professional firms that are making these assets available to retail investors. There’s another level of protection in there. And so, currently, which is a bit surprising, there are some regulatory tailwinds with making private assets and private equity available to retail investors.

And the outgoing chairman of the SEC, Jay Clayton, he has been a big proponent of what he’s called private equity to Main Street investors. How do we make that available? And from his perspective, this was kind of as he was leaving the SEC at the end of last year, these asset classes are less volatile. They have driven a fantastic return series over the last 25 years and they’ve been fairly stable.

[00:24:18] Michael Bell: They have these professional managers in place looking at these assets and who gets access to these assets? Really, the big institutions. Nobody really needs that hold the hands of the big institutions. They can take care of themselves. Why don’t we take these asset classes and make them available to the retail investor and give them some of the same benefits that the institutional investors have had for the last 25 years?

So, really, for the first time in my career, I’ve seen the regulators try to encourage retail investors to get into the private markets. One example of that is about a year ago, the Department of Labor just approved incorporating private equity and private assets into qualified plans, 401(k) plans, IRAs, and the like. And so, now you’re seeing that.

[00:25:17] Dean Barber: Yeah. And they should. So, let’s switch gears here and talk about that what you’re calling the retail investor or the individual that’s out there, that millionaire next door, maybe they got $2 million, $3 million, $4 million, or $5 million they’ve saved. They’re looking to diversify outside the public markets. Fixed income is going to be in a period of time where it could struggle with the prospect of rising interest rates into the future.

And so, people are saying, “All right. Well, what’s my other choice?” And so, I think private equity does make a choice for that but then that comes down to a couple of really important questions that I think people need to consider. One is time horizon when you decide to invest in private equity.

How long should you plan to hold that liquidity? How liquid is the private equity that’s available to the retail investor? And those two things I think are critical for people to understand. And then number three would be what percentage of a person’s equity portfolio should be private versus public? So, three great questions for you there.

[00:26:18] Michael Bell: Yeah. Great questions there, Dean. So, I’ll go off of maybe traditional private equity income and bring it down to some of the flavors of private equity that you’re seeing now for retail investors. So, private equity when they’re invested and you referenced this previously by foundations, institutions, endowments, sovereign wealth funds, they have a very, very long investment horizon. In decades, 20, 30, 40 years, that’s what they’re looking out because they’re investing those assets for a very long time. So, they have a long-dated mindset to begin with.

Traditional liquidity in a private equity firm, a private equity asset is anywhere from 7 to 10 years. And what that means is you write your check today, and some of the investment minimums are very, very high in traditional private equity. It could be $10 million investment minimum. You write a check today for $5 million or $10 million and you don’t see a return on those assets for five, six, seven, sometimes 10 years. So, that’s why you have to have kind of a long-term mindset on those companies.

[00:27:37] Dean Barber: Now, that’s traditional private equity. That’s not what’s coming to Main Street, though, right?

[00:27:43] Michael Bell: Correct. And also, to your last point about that traditional private equity, it is that long-dated asset. It could be up to 10 years and it could be 30% or 40% of a portfolio for an institutional investor. Now, let me contrast that with some of the stuff that you’re seeing in the products that you’re now seeing in the retail market, if you will. And what has happened is what caused some of these products to become available is product providers have been able to bring down the time horizon.

And so, now you can get a liquidity not 7 to 10 years, but you can get liquidity every quarter. Not like assets that are traditional mutual funds where you see daily liquidity. You can get it in one day and out the next. In some of these new private equity assets, you can get in on a daily basis but you may not be able to get out until once a quarter. Okay. So, that brought…

[00:28:51] Dean Barber: And then on that, though, there’s not even a guarantee that if you wanted to liquidate your entire position that you could, right?

[00:28:58] Michael Bell: There are some limitations on that. Right.

[00:29:00] Dean Barber: Right. So, people need to be aware of that.

[00:29:03] Michael Bell: People need to be aware that there are, again, the liquidity is quarterly on most of these vehicles and these vehicles are called tender funds and interval funds. The liquidity is quarterly. It’s not guaranteed. If there’s run on the bank, for example, then there’s going to be some limitations on that liquidity. And then when you get down to allocation was kind of the last part of your question, in terms of how much do people allocate investors, how much do they allocate to private assets, well, that’s where we look at financial advisors to really help with that individual client where their entire assets are allocated and what would be appropriate for them given their time horizon and given their need for access to cash or capital.

And that’s where a financial advisor can really help. But the overall market is comprised of about 7% of the total equity market is in private equity now. So, that would be kind of a market-neutral allocation of 7%. But you see institutions going up to 30% and 40% and some individuals taking an application to kind of 2% to 3%.

[00:30:31] Dean Barber: As a financial advisor for 35 plus years, I can see this as a 10% to 20% position of a person’s total equity piece, right? So, if somebody is 60-40, maybe or 12% at the high end in private equity down to maybe 6% private equity on the low end because that would be 10% to 20% of the total equity piece of the portfolio

[00:30:54] Michael Bell: Right. And you’re exactly right, Dean, and there are some, a number of growing schools of thought of the traditional portfolio on a go-forward basis. Now, we always have talked about a 60-40 portfolio for the last 30, 40 years, and it’s now looking because of the opening up of some of these asset classes of almost a 60-40 or I’m sorry, 60-20-20 because of where the fixed income markets are, that it will be shaved down a bit and you’ll see a little bit more opening up for alternative assets or private market assets.

[00:31:36] Dean Barber: Yeah. I could actually see that. And in fact, we’re looking at that in our organization as well because I do think that we’re going to have to look outside that normal 60-40 type portfolio, especially as we move forward. If we look at the valuations of where they are as you and I are doing this podcast and the outlook for total return in both the fixed income market and the equity market over the next decade is nowhere near what the outlook was 10 years ago or what people have experienced in the last 10 years.

And I think people tend to think that, well, if it’s done this in the last 10 years, that’s what it’s going to do in the next 10 years. And you and I know after our decades of experience in this industry, that that’s just simply not the way that it works. So, I’m super glad that I got an opportunity to spend half an hour with you here to educate our viewers on YouTube, our listeners on the podcast to what is private equity. And of course, Michael, we’re going to be making resources available through a link in the show notes, so that people can continue to get that education. With that, any parting thoughts for anything else that you think is really critical to mention on private equity?

[00:32:42] Michael Bell: I think it is this growing asset class. I think one of the biggest things about this asset class is education, understanding what it is, how it can benefit your portfolio, and what it can do overall and why it would be beneficial. So, I think most that education will be driven primarily through financial advisors but I think that’s a huge part of the growth of the private markets and private equity as we move forward.

[00:33:15] Dean Barber: Well, one of the things that I like about what Primark is doing from a private equity standpoint that is so different than what you’ve seen what I call product sponsors in the past do is it’s transparent. You know what’s going on. You’re not locking your money up for a period of time. You’re not paying advisors commissions to sell your products. None of that stuff’s happening, right?

So, this is something that if the advisor that’s working in the capacity of a true fiduciary says, “Hey, this makes sense for X percent of your portfolio,” it’s not because there’s something in it for the advisor. It’s because it’s directly benefiting the end client, right? So, that’s why you’re saying taking that private equity to Main Street, to the individual people who can really use this to help diversify their portfolio as they near retirement as they get into retirement or even for people that are in their accumulation years as you alluded to earlier, where these private equity investments are being made available in many 401(k) plans now.

[00:34:15] Michael Bell: That’s exactly right. First time that this market is opening up, I think it would be helpful for everybody to get additional education on it, understand it, and look at this asset class as we move forward.

[00:34:29] Dean Barber: Well, Michael, thank you so much for taking the time. Again, Michael Bell, Primark Capital. It’s been great to visit with you. I mean, we visited in person. We know each other but I just think that this is great education for our viewers on YouTube and our listeners to the iPod. So, I appreciate you taking the time.

[00:34:44] Michael Bell: Thank you, Dean. Great to be here.

[00:34:46] Dean Barber: All right, take care.

[CLOSING]

[00:34:47] Dean Barber: Well, I hope you got as much out of that conversation with Michael Bell as I did when it comes to private equity. Now, I have to admit I knew everything that Michael Bell was going to answer on that but I know you didn’t. And I wanted to bring it to you in such a way where you could start to digest what is private equity. For those of you out there on YouTube, I wanted to make sure that you give us a thumbs up.

Subscribe to our YouTube channel, leave comments, ask questions. Let’s start a dialogue. For those of you that are out there listening to us on a podcast, make sure and subscribe to The Guided Retirement Show Podcast, and please share this episode with your friends. And in the link in the show notes, you’re going to have access to some of the educational materials that Michael and I talked about during our interview. And we’d be happy to visit with you about how or if private equity makes sense in your personal portfolio. Thanks for joining me here on The Guided Retirement Show. I look forward to our next episode.

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