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Vanguard steps further into private equity

John Rekenthaler  |  02 Jun 2021Text size  Decrease  Increase  |  
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Stage One

At first, I was puzzled by Vanguard's entry into private equity. Then I was contented. Now I am intrigued.

When Vanguard announced in February 2020 that it had partnered with a private equity firm, HarbourVest Partners (if you wish to appeal to sophisticated clients, use the British spelling), I was taken aback. Private equity—that is, investing in companies that do not trade publicly—seemed to contravene Vanguard's brand. Vanguard represented low costs, transparency, and accessibility. Private equity funds were expensive, secretive, and available only to the wealthy.

What's more, the news arrived while industry executives were lobbying the regulator to permit 401(k)—the equivalent of super—plans to invest in private equity funds—an initiative that was roundly criticised by financial journalists. Oh, the irony. Even as the press attacked private equity "sharks" for targeting the masses, its favourite organisation, Vanguard, disclosed that it was collaborating with one of those very predators. Captain America had eloped with Cruella de Vil.

When Vanguard discussed its private equity plans, the apparent contradiction was resolved. The company stated that its newly acquired private equity capability was for institutional investors. Vanguard long ago expanded past its mom-and-pop legacy. It serves institutions not only by proffering funds but sometimes also by delivering advice, serving as a surrogate chief investment officer for organisations that wish to outsource their investment operations.

The Underlying logic

In that light, Vanguard's private equity partnership made business sense. Through its HarbourVest relationship, it could deliver a complete solution to its CIO clients. Also, Vanguard would not compete with private equity firms. Although its fund would directly purchase some positions by buying into existing deals, most of its holdings would be existing private equity funds. Vanguard was not becoming a private equity provider; rather, it was distributing that asset class to its clients.

That strategy was far removed from the aggressive expansion that the private equity executives had pitched to the SEC. My confusion abated. At some vaguely distant time, suggested Vanguard's sources, it might bring its private equity capability to its larger retail clients (although not, presumably, to its 401(k) investors), but that was not its priority. This was an institutional mandate.

Stage Two

Not any longer, it isn't. Last week, Vanguard stated that it had expanded its private equity capability, by making its private equity fund available to retail investors who meet the requisite financial standards. (Anybody may buy funds that are registered under the Investment Company Act of 1940, such as mutual funds and exchange-traded funds, but only those who meet minimum wealth and/or income requirements may purchase private equity funds.) That didn't take long!

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The company's private equity project has fared well. This February, 12 months after its initial fund debuted, Vanguard closed it, stating that the fund had "nearly doubled its target size". It then opened a second private equity fund, while releasing a white paper, "The case for private equity at Vanguard." This was clearly aimed at retail readers. Institutions need no convincing to buy private equity. But everyday investors are more sceptical, as are their financial advisors.

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Now I am curious. It's one thing to meet institutional demand. The average private equity allocation for state and local pension plans has risen steadily over the past three decades and now stands at 9 per cent, which exceeds that of any other investment save for conventional stocks and bonds. (Next comes real estate, then hedge funds.) Those customers desire private equity. Should the asset class sink, Vanguard could scarcely be blamed for giving the big boys what they want.

Bringing private equity to retail clients, though, is another matter. True, these will be unusually wealthy retail investors, as Vanguard is restricting its private equity sales to "qualified purchasers" (who must own at least $5 million in investments), rather than enabling the much larger group of "accredited investors" (which includes, among other parties, anybody who holds a license to sell securities). But the company nevertheless bears a responsibility for bringing individual buyers what they might wish to purchase but do not necessarily need to possess.

Good intentions

Indeed, judiciously refusing customer requests is not only the hallmark of successful money management but also a task at which Vanguard has excelled. When options-writing government-bond funds were the industry's biggest sellers in the 1980s, Vanguard abstained. Neither did it launch an Internet fund in the late '90s, nor a fund designed to avoid stock bear markets after the 2008 global financial crisis. (Eventually, it founded Vanguard Alternative Strategies VASFX, but not until 2015.) Ultimately, those were all beneficial decisions. The company strengthened its brand and built customer loyalty by knowing when to say no.

Thus, I view Vanguard's decision to offer private equity to individual investors, albeit only a well-heeled subset, as meaningful. If most other fund companies now offered a private equity fund, I would be sceptical. Because private equity returns are closely related to public-market results, and US equities have been the dominant performer since 2008, private equity has posted the highest gains of any alternative investment. Launching such funds now feels cynical. It smacks of promoting what will sell, not what is best for shareholders.

However, Vanguard has earned the right to be trusted. If the company maintains that private equity is more than merely this decade's fad, that is what it believes. (I would not write that sentence of most investment managers.) To be sure, Vanguard could be wrong. It possesses no special ability to predict the investment future. But if private equity does flop, as it periodically has done in the past—usually when publicly traded stocks crater—Vanguard expects that the problems will only be temporary. Otherwise, the company would not have taken this step.

Looking forward

Will Vanguard eventually bring private equity to accredited investors? Or even indirectly to everyday shareholders, which it could do through its mutual funds? (By law, registered funds are permitted to invest up to 15 per cent of their assets in unregistered securities, including private equity funds.) I see no investment reason why not. The level of account balance does not change the math. Either adding private equities improves a portfolio's risk/return profile, or it does not.

Naturally, the company is not tipping its hand. Its plans remain unknown. However, should it eventually expand further, bringing private equity to a broader audience, I will not be surprised. What has happened once can happen again.

is vice president of research for Morningstar.

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