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Vanguard, the money manager that used passive investing toup-end Wall Street's legacy model for retirement investing, isgetting active.

The fabled Valley Forge investment firm, which managed $6.2trillion in global assets at the end of last year, has announced apartnership with HarbourVest, a Boston-based global private equity firm with $68 billion undermanagement.

Is Vanguard changing its stripes? Not really. Thefirm's tens of millions of retail investors won't be impacted. Thepartnership with HarbourVest, which has taken 73 companies publicsince 1989, will only be available to Vanguard's institutionalclients, at least for now.

"As market structures have evolved over the past five to 10years, we started to look at private equity," said Chris Phillips,head of Vanguard Institutional Advisory Services.

"The depth of HarbourVest's investment team is unparalleled inthe market place," he added. "There's instant diversificationacross all of their strategies, and access to other top generalpartners, where you see more systemic returns than in public equitymarkets."

Vanguard's institutional arm—dubbed VIAS—was launched in 1997and managed $53 billion in assets as of the end of January. About aquarter are pension assets—mostly single-employer corporate plans.The rest is endowments and other not-for-profits. The unit hasrealized more than 20 percent growth over the past five years,which Phillips says outpaced the broader OCIO market.

Private equity coffers swelling

The new partnership is not Vanguard's first go at privateequity. In the early 2000s, the firm had a brief relationship witha third-party manager but ultimately walked away.

According to Preqin, HarbourVest is a top-20 private equity firmin terms of cash raised over the past decade. Previous holdingsinclude PetCo, Caesars, and Nuveen Investments. Today it countsabout 130 companies around the globe within its portfolio,including fintech, education, and benefits managementproviders.

Private equity's propulsion in the past two decades has beenwell documented. Since 2002, net assets have grown seven-fold, morethan twice as fast as the money flowing into public equities. By2017, there were about 8,000 U.S. companies backed by privateequity, twice as many as there were 10 years prior. Meantime,publicly listed firms fell 16 percent to 4,300, according toanalysis by McKinsey.

Corporate sponsors of pensions have been adding private equityand other alternatives to their portfolios, even as more are movingto a liability-driven investment strategy.

The specifics on allocations to alternatives are not availablethrough SEC filings. But analysis by Milliman shows corporate DBplans doubled their allocations to "other" asset classes, whichincludes private equity, from 10 percent of portfolios in 2005 to20 percent in 2018.

Fundraising in the U.S. hit an all-time high in 2019, surpassing$300 billion for the first time, said Adley Bowden, VP ofresearch at PitchBook, a Morningstar company that tracks theprivate equity market.

"For those paying attention to the rise of the private markets,Vanguard's entry into private equity is not a shock," said Bowdenin an email.

"Last year marked another year in which institutional investorssought to raise allocations to alternatives, specifically toprivate equity, which is a trend we see continuing. Vanguard istrying to make sure it can properly service its institutionalclients by building them on-ramps into private equity and venturecapital, which have become core to nearly all institutionalportfolios over the last decade," he added.

Question of timing

Private equity investing assumes considerable more risk thanpublic market investing, making partnering with the right managerall the more critical for Vanguard.

Analysis by Mckinsey shows between 2013 and 2018, the dispersionin returns between private funds in the bottom and top quartileswas nearly 80 percent; the worst performing funds averaged lossesof 30 percent; the top funds returned nearly 50 percent annually.By comparison, the dispersion in U.S. equity mutual funds was about7 percentage points.

HarbourVest serves as a general partner to some of its portfoliocompanies, and also has limited partner relationships.

It also partners with other private equity managers around theglobe, a central selling point as Vanguard vetted the growinguniverse of options, said Phillips.

"Partnering with managers around the world to find the topopportunities requires a partner that has local expertise and aglobal footprint," he said. "HarbourVest has long-termrelationships with other top general partners around theworld."

Phillips says those relationships will translate to reduced feesand greater transparency, the latter not always available toprivate equity investors, according to critics of the assetclass.

"This will create big benefits for Vanguard's clients," addedPhillips.

But Alec Lucas, a senior research analyst at Morningstar whotracks Vanguard funds, says there are no guarantees the VIAS'spartnership with HarbourVest will yield robust returns, and thatthe amount of money rushing into private funds could temperreturns.

"The positive case for the partnership rests on the fact thatthis is a way to diversify," said Lucas. "But I think thepartnership raises questions about timing. When money is funnelinginto an asset class it tends to lead to lower expected returns inthe future."

Lucas is not surprised by the partnership, but thinks Vanguardwill be challenged to invest clients' capital at scale.

"It's inherently risky to be investing in early stage growthcompanies, but it's becoming more common for institutionalclients," said Lucas. "It will be interesting to see how thisdevelops."

Accredited retail investors may get access, but DC plans likelyshut out

A press release announcing the partnership hinted thatVanguard's accredited retail investors may ultimately get access tothe private equity through the new relationship.

"If we believe private equity investing is a way to improve thesuccess and outcomes for our institutional clients, it would beincumbent upon us to explore other areas for accredited investors,"said Phillips.

There are no plans for future partnerships with otheralternative asset managers, but Phillips said his team isconstantly researching and evaluating product solutions.

And as for 401(k) investors? Getting the Main Street investoraccess to the options available to institutions and wealthyinvestors is a concept that is gaining momentum.

Last fall, the Securities and Exchange Commission issued aconcept release, which partly explores making it easier fortarget-date funds to invest in private equity.

Phillips doesn't seem to be holding his breath on thatprospect.

"It would be a big hurdle to overcome, but never say never," hesaid. "The big challenge is there is a disconnect between whatmakes investment sense and the reality of how regulation andlitigation work. They tend to conflict at the most inopportunetimes. Until that gets solved, I think sponsors will be reticent togo outside of low-cost investment options."