Imagine an institutional investor that allocates a big chunk of its portfolio to illiquid private assets but then needs to sell some of those investments to raise cash. Or a fund company that makes a fortune on actively managed mutual funds for decades, but its investors move their money to low-cost index trackers. Or a financial research company built around selling ratings of actively managed funds that people no longer buy.
Those may sound like three unrelated problems, but they all have a single solution, apparently: Sell private assets to financial advisers and unsuspecting retail investors.
Harvard University, a standard bearer among institutional investors, relies on its vast $53 billion endowment to fund a significant portion of its operations. The asset rich but cash poor endowment must sell some of its investments occasionally to raise money, and it may have to do so more aggressively now that the Trump administration is blocking grants to the university and alumni are cutting back on donations.
The difficulty is that 40% of Harvard’s endowment is in illiquid private equity, nearly twice its total holding of stocks and bonds. Selling only those liquid stocks and bonds would further raise its already aggressive allocation to private assets, which is probably one reason the endowment is reportedly looking to trim its private equity.
Easier said than done. Private equity is in a funk. Recent returns have been underwhelming, investors are cutting back on new commitments, and Harvard isn’t the only one looking to unload private equity. PE funds have navigated the slowdown mostly by selling their portfolio companies to each other. But the industry can only shuffle money around for so long. Eventually, it will need a new pool of buyers if it wants to exit its investments and continue to grow.
This is where retail investors come in. Harvard’s endowment is in talks to unload $1 billion in private equity to Lexington Partners, a unit of Franklin Resources Inc. The company is better known as Franklin Templeton, the venerable mutual fund powerhouse peddling high priced actively managed funds.
I counted more than 1,100 mutual funds in Morningstar’s database under the Franklin Templeton branding name, including the various share classes, only two of which are index funds. The median net expense ratio of Franklin’s funds is 0.88% per year, a tough sell when many index funds charge near zero.
The difficulty shows. Net flows to Franklin’s stock and bond products have been negative every year since 2015 and analysts expect more outflows this year and next. The impact on Franklin’s business is also evident. Operating income is about a third of what it was a decade ago. Profitability, as measured by return on equity, is down more than 80% over the same time, and the company’s market value has shrunk by about 70%.
To revive its fortunes, Franklin is pivoting to “alternative” investments that include private assets, a business that index funds can’t easily disrupt. Franklin Chief Executive Officer Jenny Johnson told analysts recently that selling alternative assets to individuals is “a massive opportunity.” Franklin already managed $250 billion in alternative assets at fiscal year-end 2024, up from $45 billion five years ago. Analysts estimate that net flows to Franklin’s alternative investments will grow robustly in the years ahead.
Franklin’s pivot is part of a bigger push by the fund industry to fight the fee compression brought on by index funds. Ironically, BlackRock Inc. CEO Larry Fink, whose popular suite of index funds drove down fund fees, is helping to lead the charge. He argued in his latest annual letter to shareholders that ordinary investors would be better diversified with private assets. He also complained that excluding them from private investments thus far has widened wealth inequality as rich investors became even richer buying fast-growing, tech-driven private businesses.
Fink isn’t wrong, but he neglects to mention that much of the wealth from private equity was made when the industry was small and the opportunities were plentiful, beginning in the 1980s through the 2000s. Now it’s just the opposite. He also leaves out that the top quartile of private equity investors took home most of the profits in that period, leaving other PE investors no better off than they would have been in stocks, and many of them worse off. I suspect the early winners in the PE game, including Harvard, which helped to popularize private assets, are beginning to wonder if the industry’s high fees and long lockups are still worth the bother.
The fees are so high, in fact, that fund companies stand to make a lot more on alternatives than they did selling stock and bond funds. Cliffwater Corporate Lending Fund, for example, is among the biggest alternative asset funds with nearly $29 billion in assets, according to Morningstar. The fund’s expense ratio is not easily located on its website or marketing materials. For that, investors must read the fine print or dig up the fund’s regulatory filings, which reveal a hefty annual cost of 3.61% a year.
Morningstar is banking on alternatives for a revival of its own. Before investors fled active managers for cheaper index investing, Morningstar was the go-to source for fund ratings. The expected surge of private asset funds is an opportunity to reinvigorate the company’s ratings. Morningstar announced earlier this month that it will rate so-called semiliquid funds — essentially alternative asset funds sold to retail investors that offer more liquidity than private asset partnerships but less than traditional stock and bond funds. Morningstar promises to reveal the true cost of these funds, a number that, judging by Cliffwater’s buried fees, may not be easy to find.
Whatever the cost, ordinary investors are decades late to the private-asset party. The investor-friendly move would have been to give everyone access to private markets from the start. As things stand, don’t be surprised if Franklin ultimately sells the private equity investments Harvard no longer wants to financial advisers and individual investors. CEO Johnson likened the process of “educating” advisers on Franklin’s alternative asset products to “hand-to-hand combat.” They would do well to put up a fight.
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