Blackstone Inc.’s private equity fund for wealthy individuals is a harbinger of two trends that many expect will transform investment management in the next decade. The first is getting a class of investors called “mini-millionaires” or “suburban millionaires” into alternative investments, and the second is pushing private equity for retail investors.
A century ago, “millionaire” meant “rich.” With mansions selling for $50,000, yachts for $10,000, servants paid $500 a year and Harvard University charging $200 per year for tuition, someone with a million dollars could live very well. Today that entire first million won’t get a mansion, or even a single-family home in some neighborhoods. It could take $50 million or so to put you in the category of a 1923 millionaire.
It was people in the $50 million and up wealth range who bought the hedge funds of the 20th century. Only later did institutions like pension funds and endowments get interested, driving growth in alternatives in the 21st century. As this investor base gets saturated, many alternative managers are looking to the $5 million to $50 million population — the mini-millionaires — for future asset growth.
About 12% of American households have at least $5 million of wealth, but that is misleading. Few people are born with $5 million. Most mini-millionaires are people over 55 who earned between $150,000 and $250,000 in their peak earning years and gradually accumulated wealth. Back-of-the-envelope calculations suggest that more than half of households headed by one or two college graduates will reach the $5 million level before retirement, plus many small business owners and others who did not graduate college — or as much as 30% of US households.
That answers the question of why Blackstone and other alternative asset managers are interested in mini-millionaires. If Blackstone can get an average of $1 million each from 1% of 40 million households, that’s $400 billion, about a 40% increase in its assets under management. And that’s just US investors. Moreover, private equity relies on cheap leverage, and higher interest rates are limiting institutional investors’ appetites for the strategy, making it more urgent to find new fields to plow.
The logic for the industry is clear, but does private equity have a place in the portfolios of mini-millionaires?
According to research published in the Journal of Alternative Investments, private equity behaves like a levered investment in small-capitalization stocks. The Blackstone fund spreads the money across 15 private-equity strategies and offers broad discretion to managers, so it’s hard to make more specific forecasts of its likely performance and risk. The research also suggests that while private equity significantly outperformed public equity on a risk- and sector-adjusted basis before the financial crisis, since 2008 public and private valuations have converged, narrowing the performance advantage of private equity, which will likely narrow further with higher interest rates.
On the other hand, the Blackstone fund gives wealthy investors access to strategies and asset classes hard to reach with traditional vehicles. Even at the same risk/return ratio as public equity, private equity offers diversification benefits. Another positive is that the fund has lower fees than many institutional investors pay — although there can be additional fees layered on by intermediaries. On the negative side, some investors might fear that the mini-millionaire retail fund won’t get the same attention and focus as institutional funds.
A standard investment rule of thumb is an investor can withdraw 4% of a stock portfolio’s initial value every year, increasing the amount with inflation, and be confident the remaining portfolio value will grow over 25-year or longer horizons. That means an investor with a $5 million portfolio can take $200,000 per year pre-tax to live on, which likely roughly matches the wage income of mini-millionaire households. So, $5 million means an upper-middle-income investor no longer needs to work.
Replacing, say, $1 million of the stock portfolio with private equity would add diversification and might improve returns, but it would increase risk substantially since it behaves like a levered small capitalization stock fund. This extra risk can be disguised because private equity investments report smoothed return streams due to valuation lags and uncertainty. It’s risk nonetheless, so a wise investor would replace, say, $1.5 million of traditional equity investments with $1 million of private equity and $0.5 million of low-risk investments like medium-term, investment-grade bonds.
The Blackstone fund allows aggregate investor redemptions of 3% per quarter, so a mini-millionaire could redeem 1% per quarter for income. But if lots of other investors choose to redeem, the full 1% might not be paid, and Blackstone can elect to stop redemptions at any time. So, the investment is both illiquid and might not produce any income for extended periods of time — making it less than ideal for those who lack alternative sources of income or have shorter investment horizons.
It's hard to know if private equity funds will be a good choice for investors since we have little performance history to analyze. This is clearly a case of investments being sold — pushed by managers who want the assets — rather than bought — demanded by investors for portfolio reasons. That doesn’t make them a bad idea, but it requires an appreciation of the pitfalls: illiquidity, the possibility of suspended redemptions, levered equity exposure, and that risk is understated in reported returns. There are also positive arguments: more diversification, lower fees than institutions pay, and the potential for higher returns.
Alternative managers will doubtless continue to pitch to mini-millionaires. Private equity may not be a winning strategy, but the idea of trillions of dollars sitting in zero-fee S&P 500 index funds keeps a lot of asset management salespeople awake at night, or asleep dreaming of the management and performance fees those dollars could generate.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our podcasts.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
Read more articles by Aaron Brown
