Do You Need A Private Equity ETF? (PSP, BDCS, BDCL)

Eric Dutram: Private equity is a very important avenue for growth and prosperity for small and medium companies in the U.S as well as globally. Private equity firms not only bring in much needed cash to the companies, but also expertise and experience to run the business in the most profitable way.

Apart from the business aspect of things, private equity firms also play a very important role in the society and economy at large. Many distressed companies are brought to life by these firms, thereby increasing income and output in the economy.

Fiscal 2011 was a year of economic uncertainties on the domestic as well as the international front (see Three Worst Performing Leveraged ETFs of 2011). However, this didn’t seem to slow down the private equity market too much over the course of the year. According to the Private Equity Growth Capital Council, private equity investments in the global space accounted for approximately $302 billion for fiscal 2011. The Average Private Equity Index ended at 110.4 points registering an annual appreciation of 14.05%.

However, during the third quarter of 2011, activities were sluggish on account of lower exit volumes. This move on the part of the PE firms was not unexpected, as the domestic and global equity market sentiment was on the negative side.

This was largely due to the broad market weakness in the second half of the year as this uncertainty helped to stop private equity exit routes making investing in the space difficult for the short term (read Three ETFs To Play The Tech IPO Boom).

Risk Return Tradeoff in PE investments

PE firms are registered as limited partnership firms, with the investors categorized as limited partners (basically institutional investors, hedge funds, pension funds and high net-worth individuals) and the management as general partners. Limited partners are basically silent partners who only contribute capital having little or no say in the management affairs of the beneficiary company.

The general partners, on the other hand, are the active partners who bring in the expertise and manage the day to day affairs of the business. The returns then are distributed among the investors on the proportion of their capital committed.

PE investments usually involve huge capital commitments and a long term investment horizon by the investor. The investments are high risk, high reward in nature. Due to this, companies in the sector generally have pretty spread out portfolios of investments.

Nevertheless, the stakes private equity firms take are usually rather large and a lack of a price discovery mechanism can make valuations difficult. Due to this reason, PE firms usually look to invest or takeover firms nearing profitability, or at the very least have figured out a solid business model (see more on ETFs at the Zacks ETF Center).

ETF approach to PE investing

As already discussed, fiscal year 2011 wasn’t very lucrative for PEs. However, going forward, the PE market is expected to generate good returns in the near future given the recent economic development domestically and abroad.

However, given the risky nature of PE investments, it is very important for the investors to carefully study the business models of businesses they invest in. Most of the time, the investors fail to depict the true picture and end up losing their capital. Exchange traded funds tracking the PE markets provide a basket approach to the space, a technique that can greatly reduce concentration risk in these otherwise volatile firms.

Another advantage of taking the ETF route to PE investments is the lower capital commitments as compared to investing directly in pure vanilla PE firms, or for those looking to create their own private equity basket by purchasing a handful of firms engaged in the industry.

For investors looking to get exposure to this specialized corner of the financial space, any of the following private equity ETFs could make for excellent additions:

E-TRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (NYSEARCA:BDCL)

Launched in May of 2011, this product is a leveraged ETF designed to provide double the exposure of Wells Fargo Business Development Company Index (200%) before fees and expenses. The free float market capitalization weighted index tracks the performance of the Business Development Companies (BDC) which are listed on the major U.S stocks exchanges.

The product, as an ETN, is a senior, unsecured debt security that pays quarterly variable coupons depending on the performance of the underlying index. As of Dec 31st 2011, the ETN has fetched an annual yield of 18.71%, ensuring that it was one of the highest yielders in the entire exchange-traded universe. Investors should note, however, that the ETN uses a monthly resetting feature, therefore the actual returns may vary substantially from what investors are anticipating.

Unfortunately, the investors are charged 85 basis points in fees and expenses per annum. Considering the very nature of leveraged products, this ETN is recommended for investors having an appetite for risk that is well above average (read ProShares Debuts -3x Long Term Treasury ETF (TTT)).

For investors looking to invest in the business development companies, but are reluctant to go leveraged, E-TRACS Wells Fargo Business Development Company Index ETN (NYSEARCA:BDCS) might be a good option. The features of this product are the same as BDCL barring the leveraged factor. BDCS has fetched an annual yield of 9.78% as of December 31st 2011 but still charges investors 85 basis points in fees and expenses.

For a true private equity play, investors should look no further than the PowerShares Global Listed Private Equity (NYSEARCA:PSP) which provides exposure to the global PE space and tracks the Global Listed Private Equity Index. The index tracks publicly listed PE companies worldwide.

The product mostly concentrates on companies from the U.S (39%). However, a good proportion of its assets are also invested in companies listed in the European markets.

Presently it holds 64 securities in all and allocates around 39% in its top 10 holdings. The product is fairly inexpensive considering it charges just 0.60% for its specialized exposure.

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Written By Eric Dutram From Zacks Investment Research   

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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