2023-12-03 07:30:31 ET
Summary
- This thesis aims to address the needs of investors looking to diversify beyond equities and bonds.
- In this case private equity in the form of the PSP ETF represents a suitable alternative investment.
- For this matter, it is important to elaborate on the risks associated with PE especially given that both Warren Buffett and Charlie Munger are against investing in alternatives.
- At the current price level, PSP is a buy.
If you are reading this article, there is a big chance that you are already invested in equities, and bonds but want to diversify further. In this particular case, analyzing the effects of the Fed pause together with the situation with corporate leverage, this thesis aims to show that putting some money into private equity using the Invesco Global Listed Private Equity ETF ( PSP ) investment vehicle makes sense.
Before diving deeper into the reasons, a comparison of the price performances shows that PSP's deep blue chart has outperformed the other asset classes including commodities in the last year.
Tellingly, PSP's latest surge seen since early November, by more than 18% shows that investors are showing a preference for private equity or PE, but it is especially during such periods of enthusiasm that it becomes important to highlight the risks.
The Risks Associated with PE
First, for those who are new to PE, this is different from an equity investment which represents a stake in the ownership of a publicly listed company. Thus, owning equity means holding a stake in a company that is publicly owned, obtained in exchange for money through your brokerage account, while for PE, only accredited investors or institutions are entitled to invest in a privately held company. As such, PE is classified as an alternative asset class, alongside private credit, real estate, and infrastructure. On the other hand, public equity and asset classes like bonds and cash are normally viewed as forming part of a separate group.
Looking further, PE investments are considered riskier because they lack the transparency of publicly listed companies whose management has to face up to shareholders every quarter. This is different for PE where PSP's issuer itself, or Invesco warns of those risks, especially for MLPs (Master Limited Partnerships) due to their operating structure. Invesco also states that little public information exists for PE resulting in risks of being unable to make fully informed investment decisions. Furthermore, risks also stem from PSP's holdings investing in less mature private companies, riskier than well-established and publicly traded ones.
Along the same lines, when one considers PE firms Blackstone ( BX ) and KKR & Co. ( KKR ) were rapidly acquiring data center specialized REITs at a premium of above 20% of their last closing stock prices in 2021-2022, or before the Fed started to raise aggressively , it is difficult not to have apprehensions as to whether the relatively high acquisition costs made in the era of cheap money may now impact their balance sheets in case rates stay "higher for longer". For this matter, PSP's shares underperformed equities and bonds by a large degree last year as charted below, as the Federal Reserve tightened monetary policy aggressively.
This means that risk-averse investors may not find this investment vehicle suitable for their portfolio. To this end, both Warren Buffett and Charlie Munger have previously advised against investing in PE.
Recent Performance Amid the Fed Pause
Still, as evidenced by PSP's better one-year recent performance in the introductory chart, investors appear to be coming back to the PE space. The main reason for this appears to be a more dovish stance from the U.S. Central Bank which has kept interest rates on hold during the last two FOMC meetings. Subsequently, softer inflation data emerged which increases the likelihood of interest rates being cut next year, or the exact opposite of what happened in 2022. Another reason is Invesco announcing a 1-for-5 reverse stock split in July this year, whereby each PSP share is entitled to the right to receive an additional one-fifth (0.2) of a share. This effectively increases the value of PSP in a portfolio.
Furthermore, for those who are worried that the lagging effects of high-interest rates may make it harder for the Fed to achieve a soft landing, a look at the historical performance of the PE asset class helps to alleviate some of those fears. Hence, it has outperformed relative to others like equities and fixed income from 2002 to 2020. Now, this period included both the Great Financial Crisis of 2008-2009 followed by a relatively calm period thereafter when monetary policy was loose with plenty of cheap money available.
To its credit, incepted in 2006, PSP has been around for more than a decade and is actively managed through quarterly rebalancing and reconstitution, for which the issuers charge 1.06%. Moreover, it is based on the Red Rocks Global Listed Private Equity Index, with the underlying fund investing at least 90% of its total assets in securities of 40 to 75 PE companies. These can be both ADRs (American Depositary Receipts) and GDRs (Global Depositary Receipts) or shares of a foreign company issued in the U.S. and more than one country respectively.
Talking sector exposure, these companies include BDCs (business development companies), MLPs, and other companies investing or lending money to privately held companies. This is the reason why Financials constitute the lion's share of the fund's holdings at 89.73% as pictured below.
Here, specialized REIT investors must have come across names like KKR which is continuously acquiring assets from all sectors of the economy like telecom, insurance, and biotech just to name a few. To perform these acquisitions, there is a constant need to raise capital, namely through its Next Generation Technology Growth Fund with the third round carried out at the beginning of November bringing in $2.8 billion .
As for Blackstone, as an alternative asset management firm, it typically invests in early-stage companies and specializes in real estate, hedge fund solutions, and other debt financing strategies. It has recently raised $2.6 billion through its eighth Real Estate Secondaries Fund.
The Diversification Perspective
Thus, Blackstone and KKR are managing to attract billions of dollars of investor money through capital raising activities to deploy into operations and growth of target companies, especially at a time of sky-high borrowing costs while people have the option to keep money in CD accounts yielding over 5%. At the same time, once a PE firm buys 100% of the shares of a publicly listed company, the latter is delisted which means that you no longer have access to the company for investing purposes.
In these circumstances, expanding your portfolio of equities and bonds to also include PE makes sense. For this purpose, one of the advantages of proceeding through PSP is that you can just buy its shares through your brokerage account and do not need to be a high-net-worth individual or institution. Investors also benefit from distributions whenever the holdings sell assets as shown below, with a SEC 30-day yield of 2.52%.
Looking across the PE space, there is also the ProShares Global Listed Private Equity ETF ( PEX ), but its AUM of only $7.96 million is a fraction of PSP's $203.83 million which also indicates that it is much less liquid.
Another of its advantages is that the Invesco ETF is trading at a P/E of 10.19x which is below its category average by 24%. Thus, adjusting accordingly, I have a target of $71.6 (57.76 x 1.24) based on the current share price of $57.76.
PSP is a Buy as Leverage is Not that Bad
To justify this positive outlook, Quant also rates PSP as Buy since November 15 based on the momentum criteria improving to B+ from B-. Further improvement was noted on December 2 with a score of A, with the liquidity criteria also seeing an amelioration.
Coming back to leverage risks, according to a recent update from the BEA or Bureau of Economic Analysis, many businesses may already have locked cheap loans before rates went up as of March 2022, which has resulted in interest paid on overall corporate debt plummeting at a level not seen since the 1980s. Well, this does not mean that these businesses will not eventually have to refinance at higher rates, but, it shows that corporate America has other levers to mitigate for the effects of higher interest rates on their balance sheets than what we generally tend to think.
Remaining within the realm of debt, PSP has largely outperformed both the Virtus Private Credit ( VPC ) and the iShares iBoxx $ High Yield Corp Bond ETF ( HYG ) in terms of total returns (which include dividend payments in case these are reinvested) during the last year.
Therefore, private equity despite bearing higher risks than both private credit and junk bonds since debt holders are paid before shareholders in case of bankruptcy, has delivered better returns. This was in addition to its outperformance for bonds and equities as seen earlier.
In conclusion, with an improved momentum score, PSP's outperformance may continue given that 2024 should not be too different from this year. The reason is that while expectations to see rate cuts at the March meeting have risen, the reality is that the Fed target for a 2% inflation rate may take time to be reached because the economy has both proven more resilient than most economists expected. At the same time, the BEA update shows that businesses have already planned to deal with higher rates which implies that things are not that bad in terms of leverage.
For further details see:
PSP ETF: The Private Equity Diversifier Since Leverage Is Not That Bad