Why Private Equity Is Worth The Risk

Private equity is a form of investment that takes place outside of the public stock market. It involves investors gaining an ownership stake in private companies. Private equity investing is defined by equity investments made in companies that are not publicly listed or traded on a stock exchange.

Qualified institutions and high-net-worth individuals typically invest in private equity through fund structures. These generally take the form of limited partnerships, which are managed by general partners (GPs) who raise capital from investors. The GPs then identify and invest in portfolio companies and are often heavily involved in their management.

Private equity is an alternative investment, comprising a variety of investment techniques, strategies and asset classes that are complementary to the stock and bond portfolios traditionally used by investors.

Greater gains

Private equity firms have been known to generate greater gains than public companies. This is mainly due to their "buying to sell" strategy, which involves acquiring undervalued or under-managed businesses, increasing their value, and then selling them for a maximum return. This strategy is rarely employed by public companies, which usually "buy to keep".

Private equity firms are also known for their aggressive use of debt, concentration on cash flow and margins, freedom from public company regulations, and hefty incentives for operating managers. These factors contribute to their ability to generate greater gains.

Additionally, private equity firms are structured as pass-through entities, which means they pass their entire tax obligation to their investors or limited partners. This allows them to avoid double taxation. The fund managers or general partners also benefit from preferential tax treatment on a significant portion of their income, which is taxed at lower capital gains rates rather than as compensation.

The private equity industry has grown rapidly, particularly during periods of high stock prices and low-interest rates. The largest private equity firms, such as Blackstone Group Inc., KKR & Co. Inc., and Carlyle Group Inc., are now publicly listed companies.

In summary, private equity firms have the potential to generate greater gains due to their "buying to sell" strategy, aggressive use of debt, tax advantages, and freedom from public company regulations. These factors attract investors who are willing to commit significant capital for years, usually institutions and individuals with high net worth.

Recession-resistant

Private equity is often characterised as a high-risk, high-return asset class. However, it has proven to be somewhat recession-resistant, outperforming during bear markets and only underperforming when public equities were up 10% or more.

Long-term focus

Private equity strategies tend to have a longer holding period than public market strategies, allowing for a more patient, active investment strategy. This means that PE groups can be proactive in making new investments when an industry encounters economic distress. They can also provide strategic guidance to portfolio companies, helping them decide whether acquisitions or reinvestment into high-returning projects makes sense.

Hands-on approach

Private equity groups have deep benches of operational talent that can help businesses pivot during a downturn. They can offer advice and resources to guide a company through strategic shifts, and use their networks to assist in renegotiating loan terms or other liabilities.

Ability to capitalise on illiquidity

The illiquid structure of private equity provides an advantage to investors during a distressed period. The structure prevents panic selling in the depths of a downturn, as decision-making power remains with professional investors who are closest to the asset. This means that rather than selling winners to meet redemptions, private equity strategies can wait for market conditions to improve before selling an asset.

Diversified portfolios

Private equity firms typically have very diversified portfolios, investing in a wide range of private capital strategies, including real estate, infrastructure, and private credit. This allows them to manoeuvre through a recession.

Greater company control

Private equity firms have more control over their portfolios than public companies, as they are not under the microscope of public markets. This allows for more experimentation and creativity when it comes to projects, without the worry of pleasing anxious investors.

Risk management

Private equity is an alternative investment class that has been rapidly growing in importance. It is often grouped with venture capital and hedge funds. Investors in this asset class are usually required to commit significant capital for years, which is why access to such investments is limited to institutions and individuals with high net worth.

Private equity funds have at least two key institutional features that differentiate them from traditional investments in traded stocks or bonds and make risk management a challenging task. Firstly, private equity fund investments are illiquid and long-term, with maturities of ten to fourteen years. Secondly, private equity fund investments involve specific dynamics of capital drawdowns and distributions. The timing and size of the capital calls are unpredictable, and cash payouts are also uncertain, although they are significant due to the bounded life cycle of the funds.

• Market risk: The risk of losses in the market prices of the portfolio companies held by a fund.
• Liquidity risk: The illiquidity of private equity partnership interests exposes investors to asset liquidity risk when selling positions in the secondary markets.
• Funding or cash flow risk: The unpredictable timing and magnitude of fund cash flows pose funding and cash flow risks to investors. Capital commitments are contractually binding, and defaulting on these payments can result in the loss of the entire private equity partnership interest.

• Crisis Management: Develop a business continuity plan to prepare for and respond to unforeseen factors such as natural disasters, data breaches, supply chain issues, and system failures.
• Emerging Technology: Evaluate the benefits and risks of adopting new technologies, ensuring they fulfill business needs, integrate seamlessly with current systems, and can adapt to changing business needs.
• Cyber Incidents: Adopt cybersecurity controls, perform due diligence risk assessments of potential portfolio companies, and develop a cyber incident response plan.
• Consumer Data Privacy: Understand and comply with privacy requirements, collect only necessary data, encrypt consumer data, and have procedures in place for providing consumers access to their data.
• Suppliers, Vendors, and Third-Party Obligations: Implement a formalized oversight program to evaluate and manage risks associated with outsourcing and third-party providers.
• Ergonomics, Post-Injury Management, and Employee Safety: Review and update safety policies and procedures, especially after acquisitions or substantial changes to the business's physical environment, to prevent workplace injuries and improve compliance.

Long-term investment

Private equity is an alternative investment class that has been a source of wealth generation for investors for many years. Private equity firms buy, manage, and sell companies, and investors in this asset class are typically required to commit significant capital for years. Due to the large capital requirements, access to such investments is limited to institutions and individuals with high net worth.

Private equity firms typically acquire mature companies, rather than startups, and may acquire private or public companies in their entirety. They then implement changes to increase the company's worth before exiting the investment years later. This strategy of "buying to sell" is rarely employed by public companies, which usually "buy to keep". Private equity firms are also not subject to the same regulations as public companies, giving them more freedom in their operations.

The outlook for private equity investing is positive for the coming decade. BlackRock's central expected return for private equity as an asset class is 11.2% over the next 10 years, compared to 8.8% for US equities and 8% for a global, balanced allocation of stocks and bonds. This has led to an increase in investments in private equity, with more financial advisors including it in their clients' portfolios. Private equity has been particularly attractive to investors due to its potential for long-term capital growth and its ability to keep investors invested through market downturns.

However, financial advisors have also expressed some reservations about private equity, including lack of liquidity, high levels of administration and paperwork, and concerns around due diligence and compliance.

Access to entrepreneurs

Access to capital is critical for small business success, and many entrepreneurs turn to private external financing in the form of debt and equity. Equity financing is rarer but can be more impactful, with angel investors and venture capitalists providing expertise, networks, and guidance that can lead to professionalization, increased chances of an IPO, and greater post-IPO survival rates.

One source of equity financing for entrepreneurs is private equity investment partnerships, which buy and manage companies before selling them. Private equity firms operate investment funds on behalf of institutional and accredited investors, and they typically acquire private or public companies in their entirety or as part of a consortium. The capital for these acquisitions comes from outside investors in the private equity funds established and managed by the firms, often supplemented by debt.

Private equity firms tend to invest in mature companies rather than startups, and they manage their portfolio companies to increase their worth or extract value before exiting the investment years later. They may bring operational and financial changes, such as cost cuts or restructuring, that the previous management was reluctant to implement. Private equity firms may also have special expertise that the acquired company's prior management lacked, such as helping the company develop an e-commerce strategy, adopt new technology, or enter new markets.

In the United States, the Committee on Small Business and Entrepreneurship works closely with the Small Business Administration (SBA) and the lending community to ensure that small businesses can obtain the financing they need. The SBA's lending and investment programs include the 7(a) loan program, which provides long-term working capital to small businesses, and the 504 loan program, which provides long-term loans for fixed assets through non-profit entities. The SBA also partners with private investment firms through the Small Business Investment Company (SBIC) Program, providing venture capital financing to small firms.

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