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What Are The Alternatives? Third Quarter 2016 A Private Funds Primer
Preface
Over the past three years, EIS has worked
with
qualified1
colleagues
and
family
members who have made more than 200
commitments to our private funds strategies.
These so-called “alternative” investment
strategies include hedge funds, private
equity, private debt, and specialty funds
managed by Neuberger Berman within our
$35 billioni alternatives business.
As with most asset classes, private funds
have an investment language all their own.
Private
funds’
distinctive
investment
processes, risk and reward considerations,
and performance measures can present a
steep learning curve for traditional equity and
fixed income investors. Indeed, private funds
often focus on institutions for which they
were originally developed.
In this edition of EIS Quarterly, we summarize
some of the fundamental topics that we have
discussed
with
qualified
colleagues
evaluating
Alternative
strategies
and
potential allocation within portfolios.
What Are the Alternatives?
As the name suggests, Alternatives generally
refer to investment classes that are less
conventional than traditional investments.
Simply put, these are investments that
represent alternatives to stocks, bonds,
mutual funds, exchange-traded funds, bank
products and other, more mainstream
investment classes.
Simplifying complex definitions, we use
“Private Funds” and “Alternatives” as 1 Neuberger Berman requires that all private fund
subscribers be Accredited Investors and Qualified
Purchasers. See myNeuberger for details and Other
Qualifications. 1 synonyms. In the report, we focus on private
equity-style alternatives funds that are:
1) generally illiquid, with strategies designed
for investment horizons of up to a decade or
more, and
2) restricted to investors with net worth,
liquidity,
and
experience
required
by
applicable regulations.
Alternatives as a general class of investment
also can include liquid fund investments
(“liquid alternatives”) as well as real estate,
commodities and other types of investments
and asset classes — each a potential topic for
future discussion.
Organization
Generally speaking, mutual funds are
investment
companies
formed
as
corporations.
By contrast, private funds
typically
are
organized
as
limited
partnerships, commonly referred to as LPs.
Private funds often are formed to enable
qualified investors (typically limited partners)
to pool their capital for the purpose of making
specific types of investments under the
direction of a fund manager (typically the
general partner.)
The partnership structure common to private
funds enables a broad range of investment
activities and strategies compared to mutual
funds, ETFs and other pooled vehicles.
Importantly, the LP structure enables reduced
regulatory
oversight,
reporting,
and
disclosure requirements, thus providing an
element of privacy that other investment
vehicles may lack.
Tax Reporting
Structured as limited partnerships, private
funds generate K-1s (officially Schedule K-1s
or Form 1065s) for each investor or so-called fund subscriber. Investors in private funds
receive K-1s for each tax year during which
they are “in the fund,” for each LP in which an
investment is made, and for each person or
entity investing (e.g., joint account, IRA, Trust,
etc.)
Professional tax preparers often assist private
fund investors with K-1s. Broadly speaking,
multiple K-1s can be “added together” when
preparing income tax returns. Nevertheless,
partnerships may provide K-1s after mid-April
tax deadlines. This, in turn, may necessitate
filing an automatic income tax extension by
mid-April (IRS Form 4868) and paying
estimated taxes – a manageable process but
one that can be new to traditional investors. 2 Qualifications
To invest in Neuberger Berman private funds
in the U.S., individuals – including employees,
family members, or clients – must be socalled Qualified Purchasers (“QP”) with $5
million or more in investments. They also
must be Accredited Investors. Employees who
are directly engaged in portfolio management
or research for one of our pooled vehicles, or
who lead a firm-wide operating or policy
function, or meet certain other requirements
may also be eligible.
(See Appendix for
details.)
Range of Private Funds
Within NB Alternatives, our private funds
include hedge fund strategies, private equity
and private debt strategies, commodity,
quantitative, and specialty strategies. A high
level
summary
of
our
capabilities,
representing $35 billion under management,
can be found at NB Alternatives.
Private equity and private debt funds
comprise a majority of our alternatives
strategies – roughly $25 billion of capital
presently
invested
or
committed
for
investment over the coming few years.
Private equity and private debt funds
generally invest in the equity and debt of
private companies, as opposed to equity and
debt investments in public companies.
A few Neuberger Berman private funds invest
in specialty private equity-style strategies,
such as retail brand royalties, residential real
estate loans, and hedge fund minority
ownership stakes, for example.
For the
purposes of this EIS Quarterly, we refer to all
such strategies simply as private equity
funds.
Whether in equity or debt, private equity fund
investments can be made one company at a
time as “direct investments,” or in multiple
companies at once, known as “fund
investments.”
These
investments,
essentially multiple investments made in a 3 single bite, can be made with new private
funds,
and
are
known
as
primary
investments. Fund investments can also be
made in pre-existing funds through so-called
secondary investments.
Finally, co-investment funds typically invest
alongside other private equity or debt
investors who may be leading an investment
transaction.
Purposes of Allocation to Alternatives
Private equity funds operate in the same
overall business and economic environment
as public investors. Private equity-backed
companies themselves may be householdname businesses, such as Burger King, Hertz,
Dell, Cinemark Theaters, and Univision, to
name a few.
However, given PE funds’ confidentiality and
long-term
investment
horizon
(recall,
investors generally commit capital for a
decade or more) private funds can take
advantage of a wider range of investment
capabilities, information, and opportunities
than public investors.
How might
portfolio? this enhance an investor’s Risk & Reward
Illiquidity
Premium
Private
equity
investment returns can be higher than
comparable public returns, and potential
reward for investors’ acceptance of private
fund illiquidity can be attractive. Arguably,
investors require a premium return to
compensate for illiquidity. For investors who
can accept such long-term investment
requirements and corresponding lack of
access to their capital, “illiquidity premium”
can provide attractive risk-adjusted return
from private funds.
Private Information, Access Premium
Non-public information, and access to the
Board, management, and operations of private companies can help enhance the
investment
success
of
private
fund
managers. Moreover, private fund managers
often strive to improve the operations, capital
structures
and
strategies
of
portfolio
companies themselves. These and other
information, access and execution “tools”
help define the private equity asset class and
its return potential.
Potential Risks and Considerations
Illiquidity is among many risk considerations
for private fund investors. A wide range of
redemption restrictions is standard across
hedge, private equity and specialty funds.
An investor’s ability to redeem invested
capital without penalty – or at all – can be
limited.
Even commitments for future
investments can be difficult or impractical to
cancel, in turn giving rise to secondary
markets for fund investments, as described
above.
Finally, unlike most equity and debt of
publicly-traded companies, holdings in private
companies may not be easily or precisely
valued. Private company valuation methods
can be less precise and more timeconsuming, particularly valuing portfolios
containing hundreds or more individual
company investments. Accordingly, private
fund investment values are often provided
quarterly – an investment consideration in its
own right.
Investment Periods & Fund Lifetimes
Private
equity
funds
typically
invest
committed capital over 3-4 years, referred to
as the investment period. Funds can call for
investors’ capital throughout this period,
roughly as investments are actually made by
the fund managers. Fund subscribers should
be familiar with the anticipated timing of fund
investments, in part so that cash committed
to a fund can be made available if and when
needed. Once the initial investment period
and possible extensions have passed, 4 typically no new investments or capital calls
can be made by the fund.
Capital calls, also known as drawdown
notices,
generally
arrive
as
email
notifications and provide at least 10 days’
advance notice for required wire transfers to
the fund administrator. Many private funds
enable automatic wire transfers from an
investor’s investment account, if desired, to
streamline capital call processes that can
occur several times per year. Funds must be
available in any linked account from which
automated wire transfers to originate.
1 Hypothetical PE Fund Lifecycle During the investment period, fund managers
often recycle or re-invest income or other
distributions that may result from initial fund
investments. Each type of fund – equity debt,
hedge, etc. – and each specific fund will
outline its practices in a private placement
memorandum or similar document.
The realization phase of a private fund, and
annual extensions that can last 1-2 years or
more, allow fund investments to run their
intended
course,
distributing
potential
investment proceeds to fund investors if and
roughly as they occur. A broad range of
investment outcomes – from M&A and IPOs,
to securities sales, interest or royalty income,
etc. – can trigger investment realizations for
fund subscribers. It all depends upon the
strategy employed, management execution,
and fund outcomes achieved.
Drawdowns
The multi-year investment
period, and even longer-term realization
period common to private equity funds,
produces a so-called J-curve depicting cash flow into and from the fund. The rate at
which a fund calls for investor capital, and the
rate at which realizations are distributed back
to investors, can vary widely.
The maximum drawdown refers to lowest
point in the J-curve, typically during the first
few years of the fund, when investors
experience the largest total cash outlay.
Figure 2 - Hypothetical J-Curve A typical maximum drawdown can range from
50% - 80% of an investor’s total capital
commitment, after which capital returned to
investors can reduce the balance of total cash
outlay, contributing thereafter to positive
cash and investment returns.
Allocation & Suitability
Our Investment
Strategy Group (ISG) recently updated our
2016 Portfolio Guidelines to include sample
allocation targets of 5% to 15% for
Alternatives as an overall asset class.
Individual fund investments typically help
diversify an overall allocation to Alternatives.
A wide range of allocation targets between
0% and 40% can apply based upon individual
client circumstances.
An allocation to Alternatives is by no means
appropriate for all investors – not even all
Qualified Investors. Yet guidelines help to
better evaluate the role that Alternatives can
play as part of a diversified investment
portfolio.
Each client considering an allocation to
Alternatives through a private fund must 5 complete a Suitability process with their
investment advisor. Suitability helps assure
that each private fund may be appropriate for
each investor’s circumstances, and typically
restricts individual investment to not more
than 5% - 10% of one’s liquid net worth.
Tax Considerations
Private funds each
have their own tax character, depending in
part upon the type and mix of investments
made within each fund. As a general rule,
interest income, dividends, royalty streams,
short- or long-term gains, etc., that individual
investments can generate are passed through
to investors. (As a reminder, funds are
typically organized as limited partnerships,
enabling the pass-through of gains, losses
and other forms of taxable activity to
investors themselves.)
For example, a private equity fund might
employ a strategy that targets long-term
capital gains. If achieved, in turn this would
cause “realizations” that are taxable as longterm gains to fund investors themselves. By
contrast, a private debt fund might pursue a
strategy that targets a blend of interest
income and capital gains.
In this case,
resulting distributions to taxable investors
would reflect the combination of income and
gains experience within the fund itself.
IRA, Roth IRA, and other tax-exempt investors
in private funds should consider the tax
treatment applicable to their respective
account type. As described above, the passthrough of fund distributions establishes the
initial character of income, gains, losses, etc.,
from the fund. Thereafter, however, the
ultimate tax treatment of distributions to an
individual depends upon the nature of, and
rules surrounding, the tax-exempt account
itself.
Costs & Fees For employees and family
members qualified to invest in our private
funds, the firm’s EIS program waives all fund
management fees and incentive fees or so–
called carried interest.
Operating costs remain part of the expense structure of the
funds themselves and impact all fund
investors ratably.
For arm’s-length, non-EIS investors, private
equity funds typically combine an annual
management fee of 1% - 2% with additional
carried
interest
in
the
investment
performance of the fund. Carried interest fees
serve as extra incentives for fund managers.
Carried interest fees generally are tied to
fund performance that may be achieved in
excess of a threshold, called the preferred
return.
Private funds fees can vary widely, often
adjust as fund lifecycles progress, and are
described in detail within the private place
memorandum for each fund.
Performance Measurement
Private
equity-style fund performance is often
represented using the Internal Rate of
Return (IRR) for the fund, typically both
gross and net of applicable fees. Performance
can also be described using the Multiple or
“realization multiple” both gross and net of
applicable fees. The Multiple presents the
ratio of (a) total distributions made to
investors, to (b) the total paid-in capital from
investors. 6 Because private equity funds typically invest
committed capital over 3-4 years, the
relationship between IRR and Realization
Multiple is important to consider when
reviewing
fund
performance.
This
is
somewhat complex but extremely important
to investor education.
Fund Minimums For qualified employees
and family members, the minimum initial
commitment to NB private funds available
through EIS generally is $25,000.
Nonemployee client minimums can vary widely as
a function of individual fund requirements,
generally from $250,000 to $10 million.
CANDIDATE TOPICS NOT INCLUDED: Discussion of the types of NB private
equity funds
Discussion of the types of NB hedge funds
Portfolio optimality using private equity
(image)
Building a portfolio of ‘rolling’ private
funds
ECI / UBTI as may impact IRA and non-U.S.
investors
Actual historical NB fund performance
Client reporting 7 8 APPENDIX
Qualifications
All U.S. investors in NB Private Funds must be “accredited investors” and “qualified purchasers.” If you do not
meet the “qualified purchaser” or “qualified client” standard, you may still be eligible if you are directly engaged
in portfolio management or research for one of our pooled vehicles, lead a firm-wide operating or policy
function, or meet certain other requirements (see below).
Accredited Investor
As defined in Rule 501(a) of Regulation D under the U.S. Securities Act of 1933, as amended, the term
“accredited investor” includes a (a) natural person whose net worth (which excludes the value of the person’s
primary residence and any indebtedness that is secured by the person’s primary residence, except for the
amount of indebtedness that is secured by the person’s primary residence that exceeds, at the time of the sale
of the securities, (i) the estimated fair market value of the primary residence or (ii) the amount of indebtedness
outstanding 60 days before the sale of securities, other than as a result of the acquisition of the primary
residence) either individually or jointly with such person’s spouse, at the time of such person’s purchase,
exceeds $1,000,000 or (b) natural person who had individual income in excess of $200,000, or joint income with
such person’s spouse in excess of $300,000, in the previous two calendar years and reasonably expects to reach
the same income level in the current calendar year.
Qualified Purchaser
As defined in Section 2(a)(51)(A) of the U.S. Investment Company Act of 1940, as amended, the term “qualified
purchaser” includes a natural person who owns $5,000,000 or more in “Investments”. In making this
determination, subtract the amount of any outstanding indebtedness incurred to make the Investments. The
term “Investments” includes cash and cash equivalents held for investment purposes, securities, real estate
held for investment purposes, commodity futures contracts, options on commodity futures contracts and options
on physical commodities traded on or subject to the rules of a major commodities exchange, and held for
investment purposes, and financial contracts, including swaps and similar contracts entered into for investment
purposes. i Citation for latest AUM from firm brochure or IQ.
documentation. As of March 2016, including commitments in the process of
Attachments: