15 Oct Private Equity: The What, Why, & How
Private Equity: The What, Why, & How
By QP Wealth Management
October 15, 2021
Historically, private equity has bested the public market for over 30 years. Sure, you should consider what benchmark and performance metric critics have adopted, but investors haven’t been pouring in capital without cause. One of the most important considerations in the debate on private equity performance is manager selection. The disparity between top-quartile and bottom-quartile private equity funds is substantial, with top performers more likely to maintain that rank. For those with access to these valued managers, private equity (PE) funds can provide more than attractive returns. The asset class also delivers equity diversification as PE funds generally have a lower correlation to public equity markets.
But what is private equity? Private equity funds invest a pool of capital raised from its investors directly in private companies or entities that are not publicly listed. In some cases, this involves purchasing shares of a public company to take it private by delisting them from public exchanges. Investor capital can be used many ways, I.e., to make acquisitions, shore up balance sheets, engage expertise, or streamline operations. The goal being for the fund, typically structured as a Limited Partnership (LP), to increase the underlying company’s value and subsequently sell for a profit to the benefit of its investors.
Private equity funds can differ considerably from one to the next. At the broadest level this difference can be defined by the fund’s underlying strategy. Venture capital, co-investments, secondaries, and leveraged buyouts are just some examples of very distinct strategies falling under the private equity umbrella. At a more granular level, funds can be further differentiated by the underlying investments which range an infinite universe of business types and lifecycle stages.
Venture capital (VC) invests in start-up companies or young businesses with a high potential for growth, usually in exchange for an equity stake in the company. The firm’s ownership can vary from a minority interest to a majority stake, as can the extent of its involvement in the company. VC investments can range from idea stage to a fully operational business. These early-stage investments tend to bear more risk and take longer to exit but draw investors with higher return potential.
One of the most popular PE strategies is a leveraged buyout (or LBO). In a leveraged buyout, the fund purchases a controlling stake in a company using a combination of equity and debt, which the company bears responsibility for. The fund then aims to increase the company’s value or profitability, thereby increasing the value of its ownership stake and decreasing the burden of the company’s debt.
Co-investments are typically minority investments made by individual investors directly into a company alongside a private equity fund (LP). Through this strategy co-investors gain access, or in some cases additional exposure, to assets that would otherwise be difficult to obtain. Additionally, co-investors rarely pay management fees or carried interest. These are favorable transactions for the LP, as well. Co-investments provide the PE fund with more favorable purchasing economics, or in some cases the opportunity to participate at all. They also help the fund manage exposure to an otherwise over-allocated investment.
Two very common and very important characteristics of alternative investments are 1) illiquidity and 2) long duration. If an investor requires liquidity and needs to exit prematurely, the only place to turn is the secondary market. This growing market represents a strategy aptly known as secondaries. Secondaries are transactions through which an investor may be able to exit their ownership in a PE fund. Typically, a buyer, who assumes the rights and any remaining commitment, purchases the interest at a valuation agreed upon by both parties. PE funds partake in secondaries as buyers and sellers to help manage a fund’s allocation and exposure.
How does everyone profit? The private equity firm commonly collects a management fee and an incentive fee from the fund. Investors, or limited partners (LPs), are distributed earnings when shares or stake in the underlying company are sold. In some cases, this event may be in the form of an IPO, as the fund takes a private company public. The incentive of an illiquidity premium that we’ve touched on in previous articles is also attributed to private equity.
So, we’ve narrowed down that private equity funds can invest at various stages, from mature companies to startups and from promising to failing companies. In some cases, funds will incorporate a combination of the above to achieve a more balanced risk/return profile. To add to the complexity, funds can also cross asset classes with investments into areas like private real estate, credit, and hedge funds. While seeking growth is generally the priority, PE funds can look and act very different depending upon their makeup.
Lastly, we size up the asset class using Morgan Stanley’s capital market assumptions return and volatility estimates. Being that the asset class is geared at providing outsized returns, comparisons are best made to equity asset classes with similar targets. Morgan Stanley’s GIC estimates that over a seven-year period publicly traded equities will deliver annualized returns of 4.9% with a volatility of 13.2%. In comparison, over the same period private equity’s annualized return is estimated at 7.6% with a volatility of 8.9%. The only equity sub-asset classes with comparable return estimates are US Small-Cap Value and Emerging & Frontier Markets, both of which have volatility estimates that nearly double from private equity (see image below). Shortly put, they estimate twice the risk for comparable returns.
Like previously covered private asset classes, participation is typically limited to institutional, qualified, or accredited investors. Minimum investments or commitments depend on the fund but can run from $250,000 into the millions. These strategies typically require long holding periods for materialization, typically between four and seven years, another feature not suitable or desirable to all investors. Most importantly, we reiterate again that manager and fund selection is most important. The complexities of these investments are best understood by professionals with dedicated knowledge and experience. When investments are properly understood and explained to investors it ensures that suitability and risk are being accounted for before placement into a portfolio.
source: Global Investment Committee, “Annual Update of GIC Capital Market Assumptions”, Morgan Stanley Wealth Management, 31 Mar 2021, Morgan Stanley Smith Barney LLC, 2021, pp. 17.
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