Vanguard, the money manager that used passive investing to up-end Wall Street's legacy model for retirement investing, is getting active.

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

Is Vanguard changing its stripes? Not really. The firm's tens of millions of retail investors won't be impacted. The partnership with HarbourVest, which has taken 73 companies public since 1989, will only be available to Vanguard's institutional clients, at least for now.

"As market structures have evolved over the past five to 10 years, 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 in the market place," he added. "There's instant diversification across all of their strategies, and access to other top general partners, where you see more systemic returns than in public equity markets."

Vanguard's institutional arm—dubbed VIAS—was launched in 1997 and managed $53 billion in assets as of the end of January. About a quarter are pension assets—mostly single-employer corporate plans. The rest is endowments and other not-for-profits. The unit has realized 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 private equity. In the early 2000s, the firm had a brief relationship with a third-party manager but ultimately walked away.

According to Preqin, HarbourVest is a top-20 private equity firm in terms of cash raised over the past decade. Previous holdings include PetCo, Caesars, and Nuveen Investments. Today it counts about 130 companies around the globe within its portfolio, including fintech, education, and benefits management providers.

Private equity's propulsion in the past two decades has been well documented. Since 2002, net assets have grown seven-fold, more than twice as fast as the money flowing into public equities. By 2017, there were about 8,000 U.S. companies backed by private equity, twice as many as there were 10 years prior. Meantime, publicly listed firms fell 16 percent to 4,300, according to analysis by McKinsey.

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

The specifics on allocations to alternatives are not available through SEC filings. But analysis by Milliman shows corporate DB plans doubled their allocations to "other" asset classes, which includes private equity, from 10 percent of portfolios in 2005 to 20 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 of research at PitchBook, a Morningstar company that tracks the private equity market.

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

"Last year marked another year in which institutional investors sought to raise allocations to alternatives, specifically to private equity, which is a trend we see continuing. Vanguard is trying to make sure it can properly service its institutional clients by building them on-ramps into private equity and venture capital, which have become core to nearly all institutional portfolios over the last decade," he added.

Question of timing

Private equity investing assumes considerable more risk than public market investing, making partnering with the right manager all the more critical for Vanguard.

Analysis by Mckinsey shows between 2013 and 2018, the dispersion in returns between private funds in the bottom and top quartiles was nearly 80 percent; the worst performing funds averaged losses of 30 percent; the top funds returned nearly 50 percent annually. By comparison, the dispersion in U.S. equity mutual funds was about 7 percentage points.

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

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

"Partnering with managers around the world to find the top opportunities requires a partner that has local expertise and a global footprint," he said. "HarbourVest has long-term relationships with other top general partners around the world."

Phillips says those relationships will translate to reduced fees and greater transparency, the latter not always available to private equity investors, according to critics of the asset class.

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

But Alec Lucas, a senior research analyst at Morningstar who tracks Vanguard funds, says there are no guarantees the VIAS's partnership with HarbourVest will yield robust returns, and that the amount of money rushing into private funds could temper returns.

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

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

"It's inherently risky to be investing in early stage growth companies, but it's becoming more common for institutional clients," said Lucas. "It will be interesting to see how this develops."

Accredited retail investors may get access, but DC plans likely shut out

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

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

There are no plans for future partnerships with other alternative asset managers, but Phillips said his team is constantly researching and evaluating product solutions.

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

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

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

"It would be a big hurdle to overcome, but never say never," he said. "The big challenge is there is a disconnect between what makes investment sense and the reality of how regulation and litigation work. They tend to conflict at the most inopportune times. Until that gets solved, I think sponsors will be reticent to go outside of low-cost investment options."

Instant Insights /

Vanguard teams with HarbourVest to advise DB sponsors' private equity sleeve

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