Institutions' Private Equity Partners: Choosing The Right Fit

Private equity is a form of investment that takes place outside of the public stock market. Private equity firms buy and manage companies before selling them, and they operate investment funds on behalf of institutional and accredited investors. Private equity funds may acquire private or public companies in their entirety or invest in buyouts as part of a consortium. They typically do not hold stakes in companies listed on a stock exchange.

Private equity is often grouped with venture capital and hedge funds as an alternative investment. 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.

Institutions will consider several factors when choosing private equity to invest in, including whether a company:

- Operates in an industry that is difficult for competitors to enter

- Generates consistent profits or can become profitable

- Provides a reliable cash flow so it can pay off debt

- Has a strong position or brand within its market

- Has an effective management team

- Is unlikely to face disruptive change through technology or regulation

- May be underperforming relative to other companies in its industry

Private equity firms have grown substantially since the 1980s and now manage more than $6 trillion in assets in the United States. Their presence has affected industries from hospitals to fisheries.

The potential for higher returns than public markets

Private equity is an attractive investment option for institutions due to its potential for higher returns than public markets. Private equity firms buy and manage companies, overhauling them to increase their value before selling them for a profit. This process often involves bringing in new management, cutting costs, or spinning off underperforming parts of the business.

Private equity funds have a finite term, typically 10 to 12 years, during which investors should expect to hold their investment. The long-term nature of private equity investments allows managers to focus on implementing strategies that may take years to bear fruit, such as improving operations or developing new technologies. This focus on long-term value creation can lead to higher growth and better margins compared to publicly traded firms.

The potential for higher returns in private equity is further enhanced by the active role that private equity investors play as owners and operators of businesses. They work closely with management teams to implement focused strategies, taking advantage of operational and capital structure inefficiencies to create value. Private equity managers are also less influenced by short-term market fluctuations and are thus able to make decisions with a long-term perspective, which can result in higher returns over time.

Additionally, private equity firms have access to a diverse set of companies to invest in, including mature companies and early-stage startups. By investing in companies with high growth potential, private equity firms aim to generate returns that outperform the public market. Historical data supports this claim, as private equity has outperformed public markets over various time horizons. For example, the Global PE Index outperformed the MSCI World Index by more than 500 bps annualized on a net basis over the last 25 years.

However, it is important to note that private equity investing carries a higher level of risk and requires a substantial amount of capital, making it inaccessible to most individual investors. The success of private equity investments depends on the ability of the private equity firm to identify and implement value-creation strategies effectively.

The ability to diversify against market and cyclical risk

Private equity is a form of investment that takes place outside of the public stock market. It allows investors to gain an ownership stake in private companies. Private equity funds are managed by private equity firms, which invest in companies and overhaul them to earn a profit when they are sold. Private equity is often grouped with venture capital and hedge funds as an alternative investment.

Institutions and individuals with high net worth are usually required to commit significant capital for years, which is why access to such investments is limited. Private equity funds have a finite term of 10 to 12 years, and the money invested in them is not available for subsequent withdrawals.

Diversification is a risk management strategy that creates a mix of various investments within a portfolio. It is the process of spreading investments across different asset classes, industries, and geographic regions to reduce the overall risk of an investment portfolio. The idea is that by holding a variety of investments, the poor performance of any one investment can potentially be offset by the better performance of another, leading to a more consistent overall return.

Diversification of Investment Portfolios

Private equity can help institutions diversify their investment portfolios by providing access to a wide range of companies and industries. By investing in private companies, institutions can reduce their exposure to any single type of asset and limit their risk. Private equity firms often specialise in specific sectors or industries, such as technology or energy deals, which can provide institutions with targeted investment opportunities.

Protection Against Market Volatility

Private equity investments are not traded on public stock exchanges and are therefore not subject to the same market volatility as public companies. Private equity valuations are not influenced by the larger market, and private companies have more flexibility in their accounting practices. This can provide a level of stability and predictability for institutions, especially during times of market uncertainty or cyclical downturns.

Long-Term Investment Horizons

Private equity investments typically have long investment horizons, often ranging from five to ten years or more. This allows institutions to take a long-term view of their investments and reduce the impact of short-term market fluctuations. By committing capital for the long term, institutions can better align their investment goals with the growth and development strategies of the companies in which they invest.

Access to High-Growth Opportunities

Private equity firms often invest in companies with significant growth potential, particularly in industries such as telecommunications, software, healthcare, and biotechnology. By partnering with these firms, institutions can gain access to high-growth opportunities that may not be available through public market investments. Private equity firms actively work to add value to the companies they invest in, such as by bringing in new management teams or acquiring complementary businesses, which can enhance the growth prospects of these companies.

Reduced Correlation with Public Markets

Private equity investments tend to have a lower correlation with public market investments. This means that the performance of private equity investments may not be closely linked to the performance of public markets. By including private equity in their portfolios, institutions can reduce their exposure to systematic or market risk, which is inherent in public market investments.

In summary, private equity provides institutions with the ability to diversify their investment portfolios, protect against market volatility, access high-growth opportunities, and reduce their exposure to systematic risk. By investing in private companies and working with specialised private equity firms, institutions can better manage their risk and pursue attractive returns.

The level of control and active ownership

Private equity (PE) firms are offered to institutional investors and limited partnerships that take an active role in the management and structuring of the companies they invest in. This is in contrast to passive investors, who are wholly dependent on management to grow the company and generate returns. Active private equity firms may have extensive C-level contacts and relationships, which can help increase revenue. They might also be experts in realizing operational efficiencies and synergies.

Active ownership is one of the fastest-growing responsible investment strategies in listed equity globally. It is generally regarded as one of the most effective mechanisms to reduce risks, maximize returns, and positively impact society and the environment. Active ownership involves a two-way dialogue with companies; investors are given the opportunity to explain their expectations of corporate management, while companies can provide clarifications on their strategy and the relationship between ESG factors, their business model, and financial performance.

Active ownership can be applied differently in each asset class. For listed equities, it includes engagement and voting activities. Shareholder engagement captures any interactions between the investor and current or potential investee companies on ESG issues and relevant strategies, with the goal of improving ESG practices and/or disclosure. Collaborative engagements include groups of investors working together, with or without the involvement of a formal investor network or other membership organization.

Voting refers to the exercise of voting rights on management and/or shareholder resolutions to formally express approval or disapproval on relevant matters. In practice, this includes taking responsibility for how votes are cast on topics raised by management, as well as submitting resolutions as a shareholder for other shareholders to vote on. Voting can be done in person or by proxy.

The use of debt financing in acquiring companies increases an investment's return on equity by reducing the amount of initial equity required to purchase the target. Moreover, interest payments are tax-deductible, so the debt financing reduces corporate taxes and thus increases total after-tax cash flows generated by the business.

Leveraged buyouts (LBOs) are a common strategy used by private equity firms, in which a company is bought out and the purchase is financed through debt, which is collateralized by the target's operations and assets. In an LBO, PE firms can assume control of companies while only putting up a fraction of the purchase price.

Private equity firms also provide operational support to management to help build and grow a better company. They can help institute new accounting, procurement, and IT systems to increase the value of their investment. They can also align the interests of company management with those of the firm and its investors.

As private equity investments require millions of dollars, they are usually not available to the average investor.

The alignment of interests between investors and fund managers

To address this misalignment, institutional investors in private equity have pressured fund managers to leave all or part of their carried interest in the fund. Taking carried interest in the form of cash reduces the incentive for fund managers to continue performing in the best interests of investors. By leaving carried interest in the fund, fund managers' interests remain aligned with those of investors over the long term.

Private equity firms act as general partners and manage fund investments in exchange for fees and a share of the profits. This typically includes a management fee of around 2% of fund assets and 20% of fund profits above a preset minimum, known as carried interest. The high fees associated with private equity investments can reduce returns for investors, so ensuring alignment of interests is crucial.

Institutional investors in private equity include pension funds, large university endowments, and family offices. These investors provide funding for early-stage, high-risk ventures and play a significant role in the economy. Private equity firms invest in companies with significant growth potential, often in industries such as telecommunications, software, healthcare, and biotechnology. They aim to add value to the companies they invest in by bringing in new management, making complementary acquisitions, cutting costs, or spinning off underperforming parts of the business.

To ensure alignment of interests, private equity firms should focus on creating value for their investors and improving the acquired companies. This can be achieved through operational improvements, cost-cutting, restructuring, and leveraging the firm's expertise to help the company develop new strategies or enter new markets. By successfully executing their value-creation plans, private equity firms can deliver returns that meet or exceed the expectations of their investors.

The opportunity to access a bigger pool of unknown companies

Private equity firms have access to a larger pool of companies that are not available for investment on public markets. Every company traded publicly faces a lot of scrutiny, and its value is likely to be recognised, driving up the price. In contrast, private equity firms have access to a bigger pool of unknown opportunities that do not face the same scrutiny. They have the resources to perform due diligence on these companies and identify which are worth investing in.

Investing at an early stage means higher risk, but for the companies that do succeed, the fund benefits from higher returns. Private equity firms tend to invest in early-stage, high-risk ventures, usually in sectors such as software, healthcare, telecommunications, hardware, and biotechnology.

Private equity funds are generally backed by investments from large institutional investors such as pension funds, sovereign wealth funds, endowments, and very wealthy individuals. They are not open to small investors and typically have high minimum investment requirements, ranging from a few hundred thousand to several million dollars.

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