Fran Kinniry: Applying the Vanguard Approach to Private Equity

Episode Summary

Executive Summary: Fran Kinniry, a principal in Vanguard's Investment Strategy Group, discusses the firm's new initiative to offer private equity investment to institutional and high-net-worth clients. He explains the rationale: private equity fills a gap in Vanguard's historically all-liquid portfolios, offering an illiquidity premium and diversification. Vanguard is partnering with HarborVest, a top private equity manager, to provide access to a diversified fund-of-funds structure. Kinniry emphasizes that this aligns with Vanguard's mission of making institutional-quality investments accessible to a broader range of investors, starting with advised clients.

Main Topics: Vanguard's Entry into Private Equity (Priority: 5/5): Fran Kinniry explains Vanguard's decision to launch a private equity offering for institutional and high-net-worth clients, starting with their OCIO business. The Illiquidity Premium and Diversification Benefits (Priority: 4/5): The discussion covers how private equity provides an illiquidity premium of around 3% and offers diversification due to low correlation with public equities. Manager Selection and the Four P's (Priority: 4/5): Kinniry details Vanguard's process for selecting private equity managers, focusing on people, philosophy, process, and performance, with HarborVest as their chosen partner. Fees, Liquidity, and Investor Suitability (Priority: 3/5): The conversation addresses fee structures, liquidity mismatches, and the importance of advising clients on the long-term nature of private equity investments. Advisor's Alpha and Behavioral Benefits (Priority: 3/5): Kinniry highlights the role of advisors in keeping investors disciplined, noting that private equity can improve behavior by being less liquid and reducing market timing. Comparison to Vanguard's History with Indexing (Priority: 2/5): Kinniry frames this move as consistent with Jack Bogle's legacy of making institutional strategies accessible to average investors, similar to how Vanguard democratized indexing.

Key Arguments: Private equity fills a gap for Vanguard investors who have historically had 100% liquid portfolios. The illiquidity premium is around 3% and is expected to persist, though potentially lower in the future. Private equity offers superior returns when selecting top-quartile managers, with wide dispersion between top and bottom performers. Persistence in private equity performance is higher due to information asymmetry and preferential access to top general partners. Vanguard's brand and scale allowed them to partner with HarborVest on favorable terms, making it accessible to clients at a competitive cost. Private equity should be part of an advised portfolio to manage liquidity needs and ensure investors stay committed long-term. Funding private equity from public equities provides diversification, not increased risk, as both are equity-type assets. The current low-yield environment makes private equity's potential 4%+ returns attractive for meeting goals like endowment spending or inflation-adjusted returns.

Data Points: Illiquidity Premium: 3% - Historical illiquidity premium for private equity, but Kinniry expects it to decline as the market matures. Private Equity as a Share of Public Equity: 20% - The investable private equity space is 20% of the public equity market by market cap. Number of Underlying Holdings in HarborVest Fund: 500-800 holdings across 35-45 general partners - The fund-of-funds structure provides broad diversification across stages and geographies. Minimum Assets for Private Equity Manager Relationship: A couple hundred million dollars - The barrier to entry for top general partners discourages small-scale entrants. Hurdle Rate for Performance Fees: 8% - HarborVest's performance fee only kicks in after returns exceed 8%, aligning interests with investors. Average Outperformance of HarborVest Funds: 500-700 basis points above median public equity - HarborVest has consistently outperformed every fund over its course by at least 500 bps. Investor's Return (IRR) vs. Fund's Return (TWR): 1-2% gap - Behavioral gaps cause investors to trail fund returns due to market timing, which advisors can mitigate. Initial Capital Return Timeline: 4 to 6 years - Investors should expect their initial investment back in 4-6 years, but total returns take up to 15 years.

Pivotal Quotes: "If our investors could improve their outcomes if they had some position in private investments, if they had the holding period and the patients, and we could find a world-class private equity manager." — Fran Kinniry: Explaining the research-based rationale for entering private equity. "We would have done this in 2009 or 2015. The why now is probably because the space has continued to grow... and Vanguard's real belief in advice." — Fran Kinniry: Responding to a question about timing and why the launch is happening now. "Jack Bogle did not invent the index fund... What Jack did is he brought indexing to non-institutional, non-billion dollar portfolios. And the same thing with Active. And so his entire history was trying to make more accessible institutional mandates that served investors well." — Fran Kinniry: Addressing concerns that private equity is a departure from Vanguard's roots, linking it to Bogle's legacy.

Implications: This initiative signals a shift for Vanguard and the industry, making private equity more accessible to high-net-worth investors. It underscores the growing role of advisors in managing illiquid assets and may pave the way for broader retail availability if regulations change. The move could pressure other asset managers to offer similar low-cost private market access.