An Introduction
Every day, the financial media reports on movements in prices of stocks listed on exchanges such as the NASDAQ. Yet there’s another world—one of private capital—that owns and operates a huge number of companies around the world. Many of these firms reside in the portfolios of so-called private equity firms, which are a cornerstone of the alternative investment landscape.
Private equity’s scale is staggering. Consulting firm Deloitte projected that year-end 2020 assets under management would be approximately $4.6 trillion, with the figure rising to between $5.3 to $6 trillion by 2025. Of their $5.8 trillion base case estimate for 2025, Deloitte suggested that $3.9 trillion would be accounted for by unrealized value, whereas the balance of $1.9 trillion would be comprised of dry powder.
Publicly-traded stocks aren’t going away anytime soon, but they are ceding significant ground to a world where companies are increasingly owned by private equity firms. As McKinsey and Co. noted in a 2019 review:
Private equity’s net asset value has grown more than sevenfold since 2002, twice as fast as global public equities. And consider the growth in US PE backed companies, which numbered about 4,000 in 2006. By 2017, that figure rose to about 8,000, a 106 percent increase. Meanwhile, US publicly traded firms fell by 16 percent from 5,100 to 4,300 (and by 46 percent since 1996). Even some large investors that had previously stayed away are now allocating to private markets, seeing them as necessary to get diversified exposure to global growth.
Key Strategies
Within the broader private equity category, there are a number of different strategies that PE funds employ. Here are some of the most common:
- Leveraged Buyouts: These transactions, commonly known by the acronym LBO, involve a private equity fund acquiring a target company. To help finance the purchase, the PE fund uses leverage in the form of debt. This debt is typically collateralized by the assets and cash flows of the firm being acquired. Importantly, it is almost always non-recourse, as the fund itself is not responsible for the liabilities. LBOs are attractive for PE funds for a couple reasons: First, they allow them to buy companies they otherwise couldn’t afford with only their own capital. Second, they present a PE fund with a compelling risk-reward proposition. If the acquisition works out, leverage magnifies the fund’s profits. On the other hand, because the debt is non-recourse, the downside is limited to the fund’s own investment.
- Growth Capital: Private Equity funds provide growth equity to mature firms that need liquidity in order to make a transformation transaction, expand into new markets, or restructure themselves. Growth capital strategies usually do not involve a change in control of the company, but rather the PE fund taking a minority interest.
- Distressed and Special Situations: Some PE funds specialize in buying the equity and/or debt of companies that in some form of financial distress. Such a strategy is pursued with an eye towards restructuring the firm, improving its profitability, and then exiting the investment with a sizeable gain.
- Secondaries: With businesses increasingly owned by PE funds and other institutional investors, it’s not uncommon for one fund to buy a private company directly from another investor. The selling party may have purchased its stake years prior, and is ready to cash out. Meanwhile, the purchasing PE fund is attracted to the investment in question because it’s bullish on the company’s prospects for the foreseeable future.
- Infrastructure: There’s been a fair amount of attention in recent years on infrastructure as an investment, and PE funds are no stranger to this asset class. PE funds are attracted to equity stakes in infrastructure because of the potential for it to spin off significant levels of predictable cash flow.
The Investment Case for Private Equity
At a basic level, the investment case for private equity is straightforward: Private firms can offer a higher potential return for investors than publicly-traded equities. Part of the reason for this is that almost by definition, there is a liquidity gap between private and public markets. Public markets, with daily trading and countless possible participants, tend to result in higher valuations than comparable private businesses. Private equity, on the other hand, takes on more risk when buying a business because these investors can’t simply exit a position in short order. Higher rewards are the compensation for this risk.
In addition to this argument, there are other reasons for investors to consider a private equity fund:
- PE funds can own or operate businesses that don’t trade on public markets. As a result, owning units of a fund may offer exposure to a growing sector or company. It can also provide some diversification for an investor’s overall portfolio.
- While debt can be a double-edged sword, the use of leverage by PE funds can increase the profits realized by its investors. And because the debt is non-recourse, there is arguably a compelling risk-reward asymmetry in this regard.
Risks
The very qualities that offer the prospect for outperformance in private equity also come with their own risks:
- While a lack of liquidity means that valuations are more reasonable than those of public equities, this can be a problem for both a PE fund as well as its investors. Investments cannot simply be ‘exited’ in short order, if either the fund or the investor needs money. On a related note, there can be lengthy lockup periods for investors in these funds (sometimes on the order of 10 years), so private equity funds can be risky if someone thinks they might need their investment back in a short period of time.
- As with any business, investments into private businesses can go awry depending on either the broader economy or factors affecting a particular industry or business. And while the use of leverage is not unique to private equity investments, overly indebted companies can be susceptible to failure, posing a risk to the PE fund.
Common Fee Structures
Private equity funds usually operate with a management fee plus performance fee model (similar to hedge funds). According to one analysis, the median management fee for the first 5-6 years of a fund’s existence is around 1.75-1.85%. And the median performance fee (known as the ‘carried interest’, was just over 20%.
What to Look for in a Good Manager?
If you’re thinking about investing in a PE fund, there are some crucial characteristics to look for in a manager. Here are two qualities to look out for:
- A successful track record: Past performance may be no guarantee of future results, but it’s always good to see a fund manager with a track record of delivering solid gains for investors.
- Expertise: With private equity, it’s crucial that the fund manager fully understands a particular sector, and has a team with the know-how to successfully guide an investment to operational success.
Looking to allocate some capital to a private equity fund? Check out PitchBoard’s page on some of the savviest fund managers operating in PE today.
