Uk Private Equity: A Guide To Getting Started

Private equity is an alternative asset class that has been described as one of the most profound shifts in the capital markets since the 19th century. It is a long-term commitment that involves investing in private companies that are not publicly traded or listed on a stock exchange. In the UK, private equity investment is booming, with £20 billion raised in 2022 across over 2,700 deals. This article will explore the different ways to invest in private equity in the UK, the risks involved, and the potential benefits.

Understanding alternatives to private equity

Private equity is an alternative investment class, but what are alternative investments? Simply put, they are investments beyond traditional assets such as stocks, bonds, and cash. They can include private equity funds, property, hedge funds, venture capital funds, natural resources, cryptocurrencies, or collectibles.

There are several reasons to consider alternative investments:

• Diversification: Alternative investments can help create a more balanced investment portfolio by providing diversification from traditional asset classes. They offer access to returns that are uncorrelated with public markets, meaning they can behave differently from traditional assets and help manage investment risk.
• Higher returns: Alternative investments can offer the potential for higher returns in exchange for less liquidity. Investors are rewarded for less liquidity and longer investment terms with higher returns.
• Access to private markets: Alternative investments provide access to private markets and companies that are not publicly traded or listed on stock exchanges. This allows investors to tap into the growth and income potential of these companies, which may benefit from wider market volatility.
• Reduced risk: By diversifying the sources of risk and types of returns in their portfolios, investors can mitigate overall risk. Alternative investments, such as infrastructure and property, can provide a natural inflation hedge.

Types of alternative investments

• Private equity: This involves investing in private companies, usually in exchange for an equity share. Private equity funds aim to acquire controlling stakes in private and public companies and are actively involved in managing their portfolio companies.
• Private debt: Capital is invested in private companies as a loan, targeting returns through yield and loan repayment.
• Property: This includes investing in office buildings, warehouses, shopping centres, hotels, etc. Returns can come from rental payments or capital growth if the asset's value appreciates.
• Hedge funds: These are investment funds that operate in public markets but use less traditional tools such as short-selling and leverage. They seek to produce positive returns regardless of how the stock market is performing.
• Venture capital: Venture capital funds provide financial backing to start-up and early-stage companies in exchange for an equity stake. They may take an active role in management and provide necessary expertise.
• Infrastructure: Investing in projects aimed at delivering essential services such as roads, schools, water, and clean energy.
• Natural resources: Investing in commodities such as precious metals, forests, and other raw materials.
• Collectibles: Investing in luxury items such as antiques, art, classic cars, jewellery, fine wine, and other collectibles.

Advantages and disadvantages of alternative investments

Alternative investments offer improved portfolio diversification and the potential for higher returns and reduced risk. However, they tend to be less liquid than traditional investments and may be harder to access and more opaque. They can also be more expensive and illiquid, with funds committed for long periods. Due to their complex and risky nature, alternative investments may not be suitable for all investors.

Portfolio diversification

Private equity is an alternative investment class that can be used to diversify an investment portfolio. It has a low correlation with public market investments, and the illiquid nature of the investment means that holdings are more likely to be sold when the best conditions arise, as judged by the manager.

Private equity investments can be used to finance startups (venture capital), inject working capital into a growing company (growth capital), acquire a mature company for growth or reshaping (buyout), or purchase assets or loans that are in distress and need refinancing (special situations/distressed debt).

When investing in private equity, it is important to diversify across funds, strategies, and vintages (the year in which the fund makes its first investment). The growing capital allocation into this asset class has enabled the growth of many strategies on top of the traditional buyout and growth strategies. Examples include secondaries, infrastructure, and special situations.

Some private equity firms have diversified their fund offerings by launching new strategies, such as growth equity funds, sector funds, and mid-market funds. However, it is important to note that diversifying too far from the core business may sap performance. Therefore, it is crucial to thoroughly assess the attractiveness of the opportunity and the ability to compete in that space.

Overall, private equity can be a valuable component of a well-diversified investment portfolio, providing access to high-growth companies and the potential for higher returns.

Active, expert ownership

Private equity investments allow investors a much higher degree of control compared to investing in a public company. This means that investors can supplement management's expertise with their own experience and personnel when it comes to enacting a growth strategy, entering new markets, or reacting to adverse events.

Private equity investors can support management with access to follow-on funding and connect them with their network of professionals. They can also appoint a non-executive director and/or chair and take a board observer position.

Private equity investors work with the company's management team to improve the company's performance and strategic direction by aligning incentives, improving business plans, making operational improvements, and strengthening corporate governance.

This 'active ownership' approach means the private equity investor will work alongside the company's management team to enhance the value of the business. This can involve all areas of operation, from top-line growth, efficiency savings, cash generation, and procurement, to supply chains, marketing and sales, improving reporting, and human resources.

Private equity investments tend to be illiquid as there is no public market to buy and sell shares, and positions may need to be held for longer periods than traditional asset classes to realise value. In exchange for this illiquidity, target returns tend to be higher than those of traditional investments.

Private equity funds usually have an initial lifespan of 10 or more years, and it is intended that by the end of this period, they will have returned to investors their share of the original money, plus any additional returns made. This generally requires the investments to be exited for cash or listed shares before the end of the fund's life.

Private equity investment strategies

• Direct Private Equity Investments: This strategy involves investing directly in a single company, either independently or through co-investments led by other investors. Connection Capital, for example, offers its clients direct exposure to UK SMEs in the lower mid-market through its direct investment team.
• Co-investments: Co-investments allow investors to access larger, more established mid-cap companies by pooling their funds with other investors. This strategy provides access to deals that may otherwise be unavailable to individual investors.
• Private Equity Funds: Investors can gain access to a range of specialist private equity fund managers who employ differentiated strategies. These fund managers are selected based on their expertise and track record. Connection Capital, for instance, offers access to such fund managers.
• Venture Capital Trusts (VCTs): VCTs invest in small businesses, usually holding shares in around 20-30 companies that are traded on the stock exchange. Investors receive shares in the VCT itself, benefiting from tax breaks such as up-front tax relief and tax-free dividends.
• Crowdfunding: Crowdfunding platforms offer a curated selection of start-up companies, allowing a large number of private investors to participate with relatively small sums of money. Successful crowdfunding stories include Scottish brewer BrewDog and challenger bank Monzo.
• Employee Share Schemes: Companies may offer employees share schemes, such as gifting shares or the right to buy shares in the future at a set price, as an incentive to participate in the company's performance.
• Exchange-Traded Funds (ETFs): Investors can indirectly invest in private equity by investing in ETFs that track an index of listed private equity firms. This option provides diversification and accessibility to the private equity market.
• Quoted Private Equity Investment Trusts: Investors can buy shares in quoted private equity investment trusts, benefiting from dividends and potential capital appreciation. An example is 3i Group, which invests in mid-market private equity and infrastructure companies.

Tax implications

Private equity taxation refers to the rules regarding the federal and state taxes you pay as a private equity investor. In the UK, private equity funds are usually structured as limited partnerships, so their investors are treated as undertaking the fund's activities and receiving a share of its profits. This means that investors are taxed on their earnings or income from their investments, depending on the structure and amount.

In the UK, the tax treatment of private equity funds is a subject of debate. While some argue that these funds are typically trading and should be taxed accordingly, others, including HMRC, consider them investing, which has different tax implications. The distinction is important because if private equity funds are considered trading, UK pension funds and charities would be subject to tax on their profits from private equity investments, and non-resident investors could be liable for UK tax on their profits from UK-centric funds under certain conditions.

When investing in private equity, it is essential to understand the tax implications, as they can significantly impact your returns. Here are some key tax considerations for private equity investors in the UK:

• Taxation of Dividends: Dividends are the income earned from shares in a company, and they are subject to federal and state taxes as part of your taxable income. In the UK, dividends are taxed at a specific rate, and the amount varies depending on your stake in the company and its profits.
• Capital Gains Tax: This is a tax on the profit made from selling an investment asset, such as real estate or stocks. The tax is only payable when you sell the asset, and it is calculated based on the difference between the purchase price and the selling price. Holding an asset for more than a year before selling can decrease capital gains taxes.
• Tax Distributions: These are payments made by the business to investors to enable them to settle estimated tax liabilities arising from the company. This improves the investor's cash flow by allowing them to plan for future taxes without dipping into their personal funds.
• Management Incentives: The tax-efficient structuring of management incentives is crucial in private equity transactions. Management teams often receive "sweet equity," which is a class of shares awarded as an incentive. The tax treatment of these shares can vary depending on the structure and jurisdiction.
• Deductibility of Interest: Private equity deals often involve external debt, and the deductibility of interest on this debt has been a key consideration in modelling returns. However, new rules and restrictions on interest deductibility, such as the corporate interest restriction, have impacted the efficiency of traditional UK private equity structures.
• Withholding Taxes: Private equity investors should consider the ability to access double tax treaties to minimise withholding taxes on dividends or non-resident capital gains tax when exiting their investments and distributing proceeds to investors.
• Substance Requirements: With the introduction of the multilateral instrument (MLI) and the principal purpose test (PPT), substance requirements have become more important for holding companies in Luxembourg and other jurisdictions. This can impact the access to double tax treaties and, consequently, the tax efficiency of the structure.
• Hybrid Rules: In structures with US tax-exempt investors, it is essential to consider the hybrid rules to avoid unintended tax consequences. Making certain elections, such as the check-the-box election, can impact the treatment of shareholder debt and potentially result in disallowed deductions.
• Tax Indemnities: Contractual tax protections in private equity transactions tend to be limited, with low caps and tight time limits. Buyers may need to rely on insurance to obtain more comprehensive coverage for potential tax risks identified during due diligence.

Frequently asked questions