Private Equity's Next Big Investment Opportunities

Private equity is a form of investment that takes place outside of the public stock market. Private equity firms buy, manage and sell companies, overhauling them to earn a profit when they are sold again.

Private equity funds may acquire private companies or public ones in their entirety, or invest in such buyouts as part of a consortium. They typically do not hold stakes in companies that remain listed on a stock exchange.

Private equity is often grouped with venture capital and hedge funds as an alternative investment class. 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 has historically outperformed public markets across time horizons.

Private equity vs public equity

Private equity and public equity are two different ways of investing in companies. They have different advantages and disadvantages for both companies and investors, and it's important to understand the differences between them.

Public Equity

Public equity refers to a stake in a company that is publicly owned and traded on stock exchanges. Anyone with an investment or brokerage account can buy shares in a public company, either directly or through mutual funds or exchange-traded funds (ETFs) that hold diversified portfolios. Public equity is widely known and highly liquid, making it a viable option for most types of investors. It is also considered one of the three main asset classes, alongside bonds and cash.

Public equity investments are generally safer and more readily available than private equity. They are also subject to more oversight and regulation, including regular reporting and disclosure requirements. This makes them less risky for investors, especially when investing in a well-diversified portfolio.

Public companies typically raise new capital through their initial public offering (IPO) or by occasionally offering additional shares to the public. Most public equity investments are not directly associated with capital raising by the target company but are instead purchasing shares from other investors.

Private Equity

Private equity, on the other hand, refers to a stake in a company that is privately owned and not publicly traded. Private equity funds pool money from many individuals or institutions and then invest it in private companies. Private equity investing is generally geared towards sophisticated or accredited investors with certain minimum requirements for net worth. These investors often have a higher risk tolerance and are seeking higher returns than they could achieve through public equity investments.

Private equity funds often focus on long-term investments in mature companies or startups. They may take an active role in managing the company, helping to improve operations, develop new products, or shape business strategy. Private equity funds have a finite term, typically 10-12 years, and investors usually cannot withdraw their money during this period.

Private equity is considered an "alternative" asset class due to its unique characteristics, such as its fund structure, stakeholder restrictions, liquidity, and risk factors. It is less regulated than public equity and is not subject to the same strict accounting practices and reporting requirements. This lack of regulation can make private equity a more attractive option for companies that want to avoid the time and financial commitments associated with complying with federal regulations.

Private equity funds are structured as limited partnerships, with investors as limited partners and the private equity firm as the general partner/fund manager. The general partner has an incentive stake in the profits and takes a more hands-on role in managing the fund's assets.

Key Differences

One of the biggest differences between private and public equity is how investors are paid. In private equity, investors are typically paid through distributions throughout the life of their investment, rather than through stock accumulation. Private equity funds also have a more complex and lengthy funding process, which can take months or years to complete.

Public equity offers higher liquidity, as shares can be easily bought and sold on public market exchanges. In contrast, private equity funds are highly illiquid, with investors often committing their money for many years before seeing a return.

Transitioning between private and public equity is complex and involves multiple steps. A company going public will issue an IPO, while a public company going private will be purchased by an investor, typically a private equity firm or group of firms, and delisted from stock exchanges.

Performance Comparison

Private equity has historically outperformed public equity in terms of returns. Data from Cambridge Associates shows that private equity has consistently outperformed stocks over the past 25 years. However, private equity is considered a high-risk investment, and investors have a greater chance of losing their money, especially when investing in startups. Private equity funds also tend to have higher fees, which can impact overall returns.

Private equity vs other asset classes

Private equity is a distinct asset class that differs significantly from more conventional investment classes like stocks and bonds. It involves investing in private companies that are not publicly traded on stock exchanges. Private equity funds are managed by general partners (GPs) or private equity firms, who aim to generate returns by enhancing the performance of their portfolio companies. This typically involves strengthening the management team, acquiring new businesses, shaping business strategy, developing new products, streamlining operations, and optimising capital structure.

Compared to other asset classes, private equity offers higher potential returns but also carries more risk. It is often grouped with venture capital and hedge funds as an alternative investment. Private equity funds may acquire private or public companies in their entirety or invest in buyouts as part of a consortium. They usually do not hold stakes in companies listed on a stock exchange.

Private equity is particularly attractive to institutional investors and high-net-worth individuals seeking to diversify their portfolios and take on more risk. The investment horizon for private equity is typically longer, ranging from 8 to 12 years, during which investors must commit significant capital. This long-term commitment makes private equity less liquid than other investments such as stocks.

One key advantage of private equity is that its valuations are not influenced by the larger market. Private companies have more flexibility in their accounting practices compared to publicly traded companies, which must adhere to strict regulations set by the Securities and Exchange Commission. As a result, private equity funds have historically resulted in higher returns, outperforming public markets across various time horizons.

However, private equity also comes with higher risks. The lack of transparency and regulation in private equity markets makes it challenging to evaluate investments and monitor performance. Private equity funds are not registered with the Securities and Exchange Commission and are not subject to the same public disclosure requirements as mutual funds. Additionally, the success of private equity investments depends on the expertise and skills of the private equity firm in managing and restructuring the acquired companies.

In summary, private equity offers a unique opportunity for investors to diversify their portfolios and target higher returns by investing in private companies. However, it comes with a higher level of risk, longer investment horizons, and less liquidity compared to traditional asset classes. The success of private equity investments relies heavily on the expertise of private equity firms in creating value within the companies they acquire.

Performance between quartiles

Private equity funds are a type of investment partnership that acquires and manages companies before selling them. Private equity is often grouped with venture capital and hedge funds as an alternative investment.

Private equity funds are managed by general partners (GPs) who make all the fund's management decisions. They also contribute 1% to 3% of the fund's capital. In return, the GP earns a management fee, often set at 2% of fund assets, and may be entitled to 20% of fund profits as incentive compensation, known as carried interest.

The other type of investor in a private equity fund is a limited partner (LP). LPs have limited liability, meaning they can't lose more than the amount they invested in the fund. LPs are typically institutional investors or high-net-worth individuals.

Private equity funds have a finite term of 10 to 12 years, and the money invested in them is typically tied up for the duration. The funds usually start to distribute profits to investors after a number of years. The average holding period for a private equity portfolio company was about 5.6 years in 2023.

When it comes to performance between quartiles, there is a stark difference in the dispersion of returns between public and private equity funds. This is because long-only asset managers are locked into a finite universe of stocks, which can lead to a lack of diversity in portfolios. In contrast, private equity funds are largely unique and not replicable by other managers, creating more opportunity for outperformance or alpha.

According to a study by consultant RVK, the spread between top and bottom-quartile funds in private equity is 12.9 percentage points, compared to 1.5 percentage points for public equities funds. This highlights the importance of manager selection in private equity investing.

Historical data suggests that top-quartile funds are followed by other top-quartile funds 40% of the time, and 70% of the time, funds that followed a first-quartile performer ended up as above-median performers. Funds that followed bottom-quartile performers landed in the bottom quartile 40% of the time.

While past performance is no guarantee of future results, private equity fund managers have demonstrated some degree of persistence in maintaining their peer performance rank from vintage to vintage in a fund series. This has been especially true for top and bottom-quartile funds and in venture capital, where manager selection appears to matter more due to the wide dispersion of historical returns observed in this asset class.

When evaluating private equity fund performance, investors can use metrics such as Multiple on Invested Capital (MOIC) and Internal Rate of Return (IRR) to measure the performance of private equity funds. MOIC describes the value or performance of an investment relative to its initial cost, while IRR represents the annual growth rate of an investment, accounting for cash flows over time.

How private equity affects portfolio returns

Private equity has a significant impact on portfolio returns, and there are several factors to consider when evaluating its role in investment strategies. Firstly, private equity funds generally invest in companies that are not publicly traded on stock exchanges. This diversification allows investors to access a larger pool of opportunities and reduce their reliance on the performance of publicly traded companies. By investing in private companies, private equity funds can take advantage of the higher potential returns associated with these businesses, which are often undervalued or undermanaged.

One of the key advantages of private equity is the ability to actively influence and improve the performance of portfolio companies. Private equity fund managers often implement strategies such as strengthening the management team, acquiring new businesses, optimising capital structure, and shaping business strategy to enhance growth and profitability. These interventions can have a substantial impact on the overall returns of the portfolio.

Additionally, private equity funds have a finite term, typically ranging from 10 to 12 years. During this period, investors are committed to providing capital as needed, which allows for a more focused and intensive approach to value creation. The limited timeframe also incentivises private equity firms to make strategic decisions and maximise returns within a specified period.

Historical data suggests that private equity has outperformed public markets across various time horizons. According to research, private equity returns have been higher than those of public equity, emerging market equities, and other traditional asset classes. This performance can be attributed to the unique characteristics of private equity, including access to a wider range of investment opportunities, active ownership and value creation, and better alignment of interests between fund managers and investors.

However, it is important to note that private equity investments carry a higher level of risk and require a long-term commitment. The illiquid nature of private equity means that investors may need to hold their investments for an extended period, and the lack of public disclosure requirements can make it challenging to assess the risks accurately. Nevertheless, private equity can be a valuable component of a well-diversified portfolio, offering the potential for higher returns and mitigating market and cyclical risks.

The effect of private equity on portfolio risk

Private equity is a form of investment that takes place outside of the public stock market. Private equity firms buy, manage and sell companies, and investors in private equity are generally wealthy individuals or institutional investors.

Private equity investments are associated with higher risk and higher returns than public markets. Private equity investments are also less liquid than other types of investments, and investors are expected to leave their funds with the private equity firm for several years on average.

There are several specific risks in private equity investing, including:

• Operational risk: the risk of loss resulting from inadequate processes and systems.
• Funding risk: the risk that investors are unable to provide their capital commitments.
• Liquidity risk: the risk that investors are unable to redeem their investment at any given time.
• Market risk: the risk of losses in the market prices of the portfolio companies.
• Capital risk: the risk that all portfolio companies experience a decline in their current value.

Overall, the risk profile of private equity investment is higher than that of other asset classes, but the potential for higher returns makes it a lucrative investment option for those with the funds and the risk tolerance.

Frequently asked questions