Markets & Finance

An ETF Ventures Into Private Equity


When there's buzz around an investment category, you can bet that it won't be long before there's an exchange-traded fund (ETF) created so that anyone can get in on the action. One that's ready to hit the block is the PowerShares Listed Private Equity Portfolio, which comes at a time when institutions are pouring money into private equity in hopes of reaping fat returns (see BusinessWeek.com, 10/8/06, "Private Equity Keeps Booming"). However, individual investors might want to pass on this ETF.

The PowerShares Listed Private Equity Portfolio, scheduled to launch Oct. 24 and trade with the ticker PSP, is based on the new Red Rocks Listed Private Equity Index, which was created and is managed by Red Rocks Capital Partners in Denver. The American Stock Exchange, which will calculate and publish the index, provided a list of 34 stocks in the index (see table, page 2), which includes the major firms KKR Financial (KFN), Apollo Investment Corp. (AINV), Gladstone Capital (GLAD), and Allied Capital (ALD).

The list also includes companies that have stakes in investment firms, such as Triarc Companies (TRY.B), the franchisor of Arby's restaurants and owner of a 64% stake in Deerfield & Co., which owns Deerfield Capital Management, a Chicago-based asset manager offering fixed income and credit-related strategies to institutional investors.

Loose Criteria? According to an Oct. 17 press release from PowerShares, the index is made up of publicly listed U.S. securities of companies that "have a majority of assets invested in privately held companies or have the stated intention to have a majority of assets invested in private companies." The companies must have a minimum market capitalization of $50 million and a closing price above $1.00 per share.

The press release goes on to say: "The Listed Private Equity Index is diversified from three perspectives: stage of investment, capitalization structure, and industry focus. Consideration is given to valuation metrics, financial data, historical performance, and the need for diversification within the portfolio." The index uses a modified equal dollar weighting and is rebalanced quarterly.

Those criteria seem loose and could mean there are "some potentially very illiquid, very volatile securities," in the index, says Dan Culloton, senior analyst at Morningstar (MORN) and editor of the annual guide Morningstar ETF 100.

Steep Expense Ratio In turn, larger-than-normal discounts and premiums in net asset value can develop between the underlying securities and the ETF price, Culloton warns. For broadly diversified ETFs that include very liquid (that is, easily traded) stocks, such as the ones based on the Wilshire 5000 and S&P 500 indexes, the premiums and discounts are pennies, he says.

What's more, the expense ratio for the ETF is going to be fairly high, at 70 basis points. On average, ETFs charge 35 to 40 basis points, and some have expense ratios as little as seven basis points, Culloton says.

Granted, this ETF will give individual investors a way to invest in private equity that they haven't had before. "Investors deserve to have exposure to private equity if they have interest there," says Bruce Bond, president of PowerShares Captial Management, in an interview. He says the individual companies in the ETF tend to be very focused on a specific area, so it's a diversified exposure to private equity. "We think it's a terrific tool that has low correlation to the domestic equity markets, and would be a good addition as a portion of someone's portfolio," he adds.

Place Your Bets But Morningstar's Culloton cautions, "This is still an extremely unproven concept." He adds that there hasn't been a private equity index on the market with a track record to analyze. "I would say it's certainly something people can live without."

Roger Nusbaum, portfolio manager with Your Source Financial and highly regarded blogger, wonders whether all of the companies specialize in different areas, and if the mix could end up performing more like the stock market than what's intended.

"I think it might make more sense, for people that are interested in this part of the market, to pick one of the stocks," says Nusbaum. He notes that buying this ETF is essentially placing bets on the portfolio companies' track record—"you can't do a forward-looking analysis on what one of these companies will do." His take: "Picking one with a specialty that you can somehow relate to might be a better bet."

Red Rocks Listed Private Equity Index


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