Episode Transcript
Sean: I'm creating a solution for them that that has not yet been available and it doesn't rely on that rule in 40 act and ETF rule where I can only own 15% of the portfolio, no liquid things, 100% of our portfolio is going to be publicly traded securities.
Indrani: Hello and welcome to the FTSE Russell Convenes. I'm Indrani De and I'm excited to talk to Sean O'Hara from Pacer about opening up private equity to more investors. Welcome, Sean.
Sean: Thank you for having me.
Indrani: Absolutely. Now this is a very fascinating topic. And let's start with the biggest question. Why private equity? Why does it hold appeal to investors and why should they consider it?
Sean: Well, I think the simple answer is: returns, right? So, you know, private equity, venture capital in today's world, you know, with fewer and fewer companies, at least over the last several years going public or staying private longer, there's a great investment opportunity there. And so up until fairly recently, sort of the domain of institutions who can have long time horizons, if you will, and don't necessarily need, you know, intraday liquidity.
But the shortest answer I can give you is that, you know, the returns over time can be good.
I will say that, you know, there are always unicorns in there and then there's always a complete bust in there. And so, you have to sort of be, you know, a little bit careful about how you're getting your exposure to private equity and venture capital, but that that return pattern over time provides for a little extra alpha over, say the broad-based index like the Russell 1000.
Indrani: And it's very interesting because you know, most people will just say, oh, private equity because it has higher returns, but you provided the economic intuition; It's because there are fewer listed companies and many more companies staying private for longer. That is inherently the reason why, you know, you tend to see the higher returns. So, another point that you mentioned is how private equity was traditionally only for institutional investors and now you see more retail interest and opportunities for the retail investor to get into these asset class.
So what are the changes that are leading to this? Your thoughts on that?
Sean: I think there's been a movement in terms of some of the high-net-worth investors, you know, I, I would love like, you know, family offices in with institutions, right, or endowments, I would call that institutional. But on the retail side, they've been building investment products that will allow a retail investor to get access.
Now there are some restrictions, you know, you have to be a qualified investor, and you have to go through some hoops and all of that. But I think that the appetite is there for the retail investor to want to participate. The retail marketplace, at least in the higher net worth arena has been opened up here over the last several years through some of the bigger wirehouse firms and things of that nature.
So, you know, I think that's an important change, if you will. You know, at the at the end of the day, you know, private equity, venture capital are about investing in companies that will give you a return over time, right?
This opens up an additional source of capital for people to be, you know, to be deployed in that way and so I think it's probably good for the ecosystem, good for the overall U.S. economy, and good for smaller businesses that are, you know, that are not necessarily ready to go public, but are building great franchises and things of that nature to have access to more funding and more capital. So, I think it's, you know, in the long run, it's probably a good thing.
Indrani: When institutional investors invest in private equity, they tend to do directly through the funds, whereas when the retail investor needs to invest, it is typically a liquid wrapper. There's an index and an ETF link to it. Now this, adding the additional liquidity for the retail investor, do you think that changes anything about the inherent characteristics or performance over time?
Sean: No. So let's be clear about this, right? So traditional private equity is usually done through some kind of a, you know, like an LLC or some kind of a fund that is set up outside and that's generally how people get access. I think, you know, like, let's have a broader discussion about private equity and venture capital and say that, you know, everybody would have loved to be an early investor in, you know, Uber and SpaceX and you have all these, you know, huge successes.
But the truth is that for every one of those, there's probably five that didn't ultimately make it. So it's a, it's a different business model. You know, you're not going to see, you know, 25, 50, 100 companies in the Russell 1000 go broke this year or completely cease to exist, right?
So the wrapper that has been available has been one where it's set aside in a fund, but that's not liquid, right?
You have to make decisions, you know, like who do I give my money to? Like, you know, is it this manager or that manager? And you know, what's their track record look like? And you know, what are the names that they are trafficking in or what is their specialty or they roll up guys or are they tech guys? Are they cybersecurity guys? And they're sort of, you know, this potential hit and miss, if you will, like if you don't get into the right fund with the right management and they don't have success and it's not going to be a very appealing outcome.
From Pacer ETF's perspective I want everybody to know a couple of things. One is an exchange traded fund can't own illiquid names except for 15% of the portfolio. Now that's not what we're doing, I think that's a bad model anyway.
I don't, because of the 15% of the portfolio that's in sort of these hybrid products where it's 85% publicly traded securities and 15% illiquid stuff, there's generally only one exit for that door. And if you have, you know, redemptions in your fund, it can create a lot of challenges. So, I'm not a big fan of that.
What we've done here with FTSE Russell in partnership with you guys as you guys are benchmark people, right? And so, you've been benchmarking private equity and venture capital for two decades now.
And that is the entire universe of every private equity name, and every venture capital name is north of 20,000 companies.
And so, we know what the aggregate return of everything in private equity and everything in venture capital and the aggregate return of all those names is where that premium return comes from because it's higher than traditional publicly traded securities or that you would get from the Russell 1000, let's say.
When you think about what we're doing, we're working with the group in Chicago, DSC Quantitative and they figured out how to build a portfolio that can mimic the return of your benchmark indexes and they do it with 200 publicly traded securities.
I can look at your benchmark and I can say what percentage of its tax, what percentage is industrial, so on and so forth. I can take that group, and I can market cap weighted as well as like any traditional index would do. And so they start with that framework, right, and they build this portfolio of publicly traded stocks to mimic that broader indexes return.
And you wouldn't think that you might have a chance to get a little higher return out of that, but you actually do because when you start to think about the fees in private equity and venture capital, you know, it's usually some kind of two and twenty or two and ten.
And so even if you had a big, you know, successful run and it averaged 20% over a decade, the net investment return to the shareholder might only be like 16 or 15% here in the ETF wrapper. By replicating the return of your broad-based index, we're going to get, you know, we charge 85 basis points for the ETF, but you're going to get a much higher net return where this I think fits and the ecosystem, right.
I'll talk about institutional for a minute, like they can continue to buy private equity and venture capital and its illiquid form because they have long time horizons. But where I think it might fit there is to take that allocation, whatever that is, say it's, you know, 25% of their assets or something like that, and take a piece of that and put it in something like PEVC where you're getting private equity venture capital returns, but it's now fully liquid, so you have more flexibility.
And where it fits for the public is I don't have to be an accredited investor to invest in this ETF because it doesn't actually own the private equity or venture capital names. It owns a portfolio of stocks that's meant to mimic or optimize the return of your broad-based index. And so, there's no barriers to entry, there's no tie ups. You have liquidity on a daily basis.
And it doesn't matter to us if somebody buys one day and sells the next day because the portfolio's liquid publicly traded stocks. So, it's easy to readjust the amount of money in the fund and the holdings. And so, it's a pretty interesting opportunity that's developing here and it's, you know, it's a way to sort of democratise, if you will, access to those returns without having to take all of the other would some people would say are bad things but where those bad things lead to the higher returns, which is, you know, you're tied up for longer.
So you get this ill liquidity premium out of private equity venture capital. You can actually receive that in an ETF like PEVC, which we built with you guys. You can get that liquidity premium and a liquid wrapper, which is kind of cool.
Indrani: We talked about many of the changes that are happening in this asset class and the investors in this asset class. What are your thoughts on where we go from here? What kind of changes do you see happening potentially over the next three to five years?
Sean: You know, I think it probably will continue to grow. This is going to be an interesting year because there's going to be a lot of mega IPOs that will probably spur more people's interest. And you know, what is this private equity venture capital thing and how do I get in it?
By providing a solution for, you know, the, the retail investor, if you will, or the retail investor who, who deals with the financial advisor to be able to have, you know, a position here, I think makes a lot of sense.
You know what you can tuck it into. Let's see the alternative bucket, if you will, of a portfolio. And, and like I said, you know, everybody sort of always is looking for the ways to get higher returns out of their portfolios, advisors and clients and things of that nature.
And, and you know, I'm a big, I own the ETF. I think I might be the largest shareholder of the ETF, but don't quote me on that, but I really like the idea because I view it as a way to get that illiquidity premium in a wrapper that cost me less than fees, and so I get a net higher return. The most important thing here is that, you know, in that broad universe, just like in the stock market, there are big winners and big losers, right?
So I'm essentially just creating a beta portfolio for private equity venture capital returns for the retail investor and the institutional investor who wants to have a little bit of liquidity in that part of their portfolio I'm creating a solution for them that that has not yet been available and it doesn't rely on that rule in 40 act and ETF rule where I can only own 15% of the portfolio, no liquid things, 100% of our portfolio is going to be publicly traded securities.
Private equity is known for having this very high dispersion and returns that you referred to. And this is a beta version of the private equity asset class.
Indrani: Yeah, I asked you many questions, but did I miss anything in the questions? Anything that you would like to add as a last thought on this topic?
Sean: This may sound like a confusing or complicated solution, if you will. It's something we do already. So, if I was to license a broad-based fixed income index from Footsie Russell, right, it would have thousands of bonds in it. Well, I can't really own thousands of bonds in my ETF portfolio.
So what I'm, what I will do is I'll run it through a port, an optimization screen so that I can own 200 bonds that'll give me the return of 1000 bond portfolio, right? This is no different than that. I'm not taking a position in all 20,000 plus stocks. I'm essentially saying I'm going to beta match, sector match and then return match that portfolio. So like I can take the payout ratios of, you know, private healthcare versus public healthcare. And if private Healthcare is 1.3 times, then I'll just lever up my public healthcare piece of it so I can optimize the returns here to create that beta exposure to the broad index.
You're going to have some unicorns and some big winners in there. But it's not like you were going to be putting all your money, let's say, in, you know, into SpaceX and you're going to get 50 times your money. But that will be represented in the broad index. And so, I think it's kind of an interesting way to sort of get access.
Indrani: Thank you for sharing your insights with us.
Sean: Thank you.
