Investing In Private Equity

By: Chadd Evans, CFA, CAIA in Macro Commentary August 28, 2020

Investing in Private Equity

Over the past several decades, private equity (PE) investments have increasingly gained investor interest.  Large institutions, such as pension plans and endowments, were among the first to identify that private equity offered a unique opportunity to earn returns that have historically exceeded those posted by publicly traded equity indexes.  The lengthy time horizons of these investors’ portfolios rendered unimportant the long commitment periods required for investors in private companies.

It wasn’t long before family offices and high net worth investors followed suit. And today, PE investments are considered a core allocation in a well-rounded portfolio.

Average Private Equity Allocation by Investor Type

What is Private Equity?

Put simply, private equity investment funds take ownership stakes in private companies with the objective of selling this stake at a higher price at some point in the future.  Beyond this common definition, however, investments across private equity funds vary greatly.

Venture Capital and Growth Equity. PE managers typically focus on a specific lifecycle stage of a company.  And while some funds have expertise in early-stage firms (commonly referred to as “venture” capital – arguably the riskiest segment of the sector), a larger percentage of the funds focus on companies that have reached a greater level of maturity.  Many such PE managers specifically provide “growth equity” to assist companies in an acceleration or growth mode.  These firms may bring expertise, along with capital, with the overarching objective of helping the company to grow rapidly while leaving current management in place.

Buyout strategies. Contrast this with the characteristics of “buyout” PE strategies.  Managers of a buyout fund are seeking to acquire one or more companies in an industry, “buying out” some or all of the current owners’ stakes, using a combination of investor equity and debt. While these investors are often helping founders to exit their firms (and new management is brought in), in other cases, the management team is part of the new ownership structure.  Across all buyout structures is a desire on the part of the PE firm to create and extract value from the new entity in order to facilitate a profitable exit, years down the road.

Distressed. Companies can get into financial difficulty by any combination of cyclical factors (an economic downturn that impacts sales) and financial leverage (which magnifies any cyclical issues.)  A private equity firm may, therefore, find attractive opportunities when a good company with a bad balance sheet meets a difficult economic environment.  PE firms can acquire stakes in such companies, giving them a bridge to the other side of the difficult period, and then exiting the position once the company has re-established itself as a profitable entity.

What are PE’s main characteristics?

They are “private”. Private equity investments are, by their very nature, private.  And as such, PE investments have no trading liquidity.  Investors who place their capital into a PE fund can expect the acquisition, management and exit process to take years.  During this period, the managers will be incurring expenses, so the capital that investors have contributed will be used both to acquire stakes and to compensate the managers, consultants, accountants and other experts who help manage this process.

The structure is typical for partnerships. Private equity investors participate in these investments as limited partners.  The PE firm manages the partnership as the general partner.  Limited partners have no management responsibilities, and their liabilities are limited to the capital they have committed.  LPs participate in the profits of the partnership after fees and expenses are paid.

It’s a long-term commitment. With capital generally flowing towards making acquisitions and managing the fund, investors should not expect any cash distributions or income until the fund starts making profitable exits.  The exit process can be lengthy, and PE funds are likely to have many of their portfolio holdings in various stages of sale.

Profit potential is substantial. The allure of private equity is that, even after this time and expense, successful managers can help companies grow to a larger size, enhance their profitability and make them far more valuable over time.  It is also common that founders reach a growth plateau or simply wish to create a succession plan to exit their business.  PE buyers can play an important role here.  And acquiring several competitors in an industry can further create value by building a firm with the critical mass to be attractive to a large “strategic” buyer.  The profitable exit, at a multiple of the purchase price, is the objective from the outset, and is the motivator for investors who place their capital in this sector.

Private Equity Trailing 10, 15, and 20 Year Annualized Returns

Reporting is unique. Private equity investments do not update the value of their positions more frequently than on a quarterly basis.  Tax reporting comes in the form of an annual IRS Form K-1.  Additionally, these funds report results to their investors with descriptions of important developments among portfolio holdings, updating valuations as necessary.  This lack of a daily “mark-to-market” contrasts markedly with publicly traded stock market investments. Positions in PE investments can therefore provide short term portfolio stability, while long term returns will still, of course, be impacted by economic and market forces.

Idiosyncrasies of Private Equity

Expect the “J-Curve”. As mentioned above, private equity funds have a long cycle of research, management, growth and an exit.  With much of the expense front-loaded, PE funds have an unusual phenomenon called a J-curve.  Even the best PE funds will see expenses negatively impact the fund’s net asset value in the early periods.  The “J’ shape tracks early losses before growth occurs in later years.

The capital call process. Additionally, it takes time for PE managers to find attractive investments and execute deals to purchase their stakes.  Investors will have their capital “called” by the fund over a period of years (usually 2-3 years) as the managers find opportunities to deploy the capital profitably. Investors should not be surprised to receive these “capital calls” on a quarterly basis.  From a return perspective, investors applaud this approach.  Otherwise, uninvested capital sits in the manager’s bank account earning very little and dragging down the total return of the fund over time.

Access. No doubt, private equity funds would like to manage as much investor capital as they can successfully handle.  But at the same time, fund regulations and each fund’s approach to fundraising can exclude many investors from participating. These exclusions are based on the wealth and/or income levels of the permitted investors.  In principle, funds that limit their investors to the highest strata (called Qualified Purchasers, with $5+mm in net worth) can take on the most investors (and thus have the largest funds.).

In the middle, are funds that accept Qualified Clients (about $2mm in assets), while a fund that allows so-called Accredited Investors (who have more like $1mm) can take far fewer.  Investors with less than $1mm in assets must generally look for investments in the public markets.

It’s a commitment.  Private equity investors should be prepared for a long-term commitment.  While each fund is unique, an investor should expect a ten-year cycle that consists of the investment period described above, a “management” phase to affect change at the acquired companies, and a third period of attempting a sale.  Market and economic conditions can greatly impact both the performance of the portfolio companies and the time that it takes to exit them.  PE managers have financial incentives to maximize the exit price, so their judgment is critical in determining the appropriate exit time and price.

Networks and teamwork. Successful private equity firms have vast networks from which they source deals.  So-called “sponsors” may be their partners in an acquisition, sharing in the upside and bringing resources and expertise to the enterprise.  Similarly, PE managers are in contact with potential buyers of portfolio companies and with investment banks who can market a company for sale.

Cycles matter. Like all investments, private equity has distinct cycles when a large amounts of capital are raised or when investors have a lesser appetite for such vehicles.  At cycle peaks, the largest funds raise billions of dollars – often to the detriment of investor returns. (It gets increasingly difficult for managers to find attractive opportunities at large size.)  As such, there is a well-documented advantage to investing in smaller and mid-sized funds.

The “Vintage Year” phenomenon. Lastly, PE investors should consider spacing their investment over a period of years. Economic conditions at the time of a fund’s formation, and within a few years after, have a large impact on the returns that can be generated. In fact, some of the best PE returns have come in periods shortly after periods of financial crisis or economic contraction.  Which “vintage years” will be most profitable can only be determined in hindsight, so experienced PE investors often choose to initiate their investments over many different years, improving their chances of having a few that are among the most fortuitous.

What has changed and why it matters?

The American stock market has been shrinking – the public market is less than half the size of its mid-1990s peak, and 25 percent smaller than it was in 1976.  Consolidation has reduced the number of companies listed on public exchanges and has concentrated capital into a small number of corporate blue-chips on the other end of these acquisitions (e.g. Microsoft, Facebook, Amazon, Apple, Google).  At the same time, private markets are taking on a more important role in the global economy and in investment portfolios.  Last year, companies in the US received twice as much capital from private channels than they raised in the public offerings.

As access to private capital has evolved over the years, many businesses now stay private longer – and when they do go public, it tends to be at a comparatively later stage in their growth cycle.  This means that companies’ highest growth stages are now taking place in the private sphere.  Consequently, a traditional portfolio of publicly traded stocks and bonds fails to capture the most transformative elements of value creation in our economy.


Summary

Private equity funds are appropriate for long-term investors who seek returns in the form of capital appreciation, as opposed to income.  There are many approaches to acquiring private companies, but all PE funds are illiquid investments that promise higher returns in exchange for patient investor capital.  Short term price fluctuations are not a characteristic of PE funds, but long-term returns are highly dependent on economic conditions, valuations at the time of the investment’s initiation, and the size of the fund itself.   Not every investor can get access to private equity funds, but increasingly high net worth individuals are part of the equation.

By: Chadd Evans, CFA, CAIA

Managing Director

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