Success in investing isn't just about selecting suitable investments - it's also about having access to the best ones. That's why access-constrained funds, or those with access to privileged opportunities, tend to outperform their peers.
In today's Private Equity market, funds of funds and other financial intermediaries can create value not only by selecting but also by being able to access the best investment opportunities.
Why Access Constraints Lead to Outperformance
Pundits often criticize investing minimums, viewing them as a way to keep retail investors from committing capital. While this may be the case in some instances, we believe that, generally, investing minimums exist for a fundamental reason: to ensure that only sophisticated investors with a long-term orientation can commit capital.
The first access constraint is a minimum committed investment, which reaches as high as $25 million. The high minimum investment size means that many smaller investors are excluded from committing to the best-performing funds. The second access constraint is the number of investors in a fund, which is typically limited to between 10 and 20.
The high minimum investment size and the limited number of investors in a fund are two key factors that lead to outperformance. By restricting the number of available investors, GPs can avoid the crowding effects that lead to downward pressure on returns. In addition, by only allowing sophisticated investors to commit capital, GPs can avoid short-termism that can lead to suboptimal decision-making.
The combination of these two factors – the high minimum investment size and the limited number of investors – leads to a situation where GPs can access more exclusive investment opportunities and are more likely to make successful investments.
Access-constrained funds have a proven track record of outperforming their peers, and LPs with access privileges tend to recommit to these types of funds. If you're looking to invest in private equity, don't just focus on who's making the investments - also consider who has access to the best opportunities.
Sophisticated Investors and Long-Term Orientation
Alternative investments are becoming more mainstream, with retail investors flocking to riskier assets in search of higher returns. However, these investors typically invest for relatively short-term goals: to make a quick profit and move on to the next opportunity.
Study after study confirms that retail investors dramatically underperform the market and professional investors over the long term. Further, as a UCLA analysis reveals, aside from "meme stocks" like GameStop, retail investors are terrible at momentum investing and consistently underperform. Why is this?
There are several reasons, but one key reason is that retail investors don’t have access to the best investment opportunities. They lack the relationships, knowledge, and experience to identify and access the best deals.
In contrast, the investors in access-constrained funds are sophisticated institutional investors with a long-term orientation. These investors are more likely to be patient and take a hands-off approach, giving GPs the time and space they need to make successful investments.
Moreover, private equity fund terms are lengthening, and "some funds now permit extensions for an indefinite number of successive one-year periods." This trend is likely to continue as LPs are becoming increasingly comfortable investing for the long term.
The idea of an "unlimited time horizon" is also limited to institutional investors who can commit large sums of money for long periods. For retail investors, even a ten-year time horizon can be daunting.
The J-Curve Calls for a Long-Term Orientation
The importance of a long-term orientation is reflected in the very nature of Private Equity returns, which typically follow a J-curve.
The J-curve is a graphical representation of the typical path of a private equity investment. In the early years, the investment loses value as the PE firm incurs costs to acquire and turn around the business. In the later years, the investment gains value as the business improves and is sold for a profit.
Because of the J-curve, investors in PE need to be patient and have a long-term time horizon to realize the total potential return on their investment.
SoftBank's Vision Fund is an apt example of the J-curve at work. The fund, which was launched in 2017, was expected to lose $24 billion in 2020. However, the fund's backers remained confident in the long-term strategy and remained patient for the J-curve to play out. In 2021, the Vision Fund’s critics were proved wrong as the fund reported a $45 billion group net profit.
A Stickier Investor Base
The investors in access-constrained funds are typically a very select group of institutional investors, many of whom have known each other for years. This exclusive group is incentivized to maintain good relationships as they compete for a limited number of high-quality investment opportunities.
The result is a "stickier" investor base, which is much less likely to redeem its investments early. This sticky investor base gives GPs the time and flexibility they need to make successful investments without worrying about the short-termism that can plague other investors.
In addition, this exclusive group is typically very well-informed about the private equity market and has a deep pool of knowledge to draw upon. This allows them to make better-informed investment decisions and helps to improve returns further.
Passive Strategies Lack the Access Edge
In the "passive" versus "active" debate, it's essential not to forget that not all active strategies are made equal, and those with access constraints have a clear edge.
Passive strategies, such as index funds, are based on the premise that it is difficult to "beat the market." However, this logic does not apply to private equity, where the best-performing funds are often those with access to the most privileged opportunities.
Many of the world's best investors, such as Warren Buffett and George Soros, have made their fortunes by investing in opportunities unavailable to the general public.
Therefore, when it comes to private equity, access constraints matter. To achieve superior returns, investors need to access the best opportunities, which can only be done through active, access-constrained deployment.
Gain Access
Gridline is a digital wealth platform that provides a curated selection of professionally managed alternative investment funds. It enables individual investors and their advisors to gain diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.
With Gridline, you can access the best opportunities in private equity without meeting traditional funds' high capital minimums. And because Gridline only works with experienced fund managers, you can be confident that your money is in good hands.
So if you want superior returns in private equity, ensure you have access to the best opportunities. With Gridline, you can.