Unlocking Private Equity: The Benefits Of Listed Investments

Private equity has long been an attractive prospect for investors, with its unique characteristics making it an asset class that can drive up returns. Private equity firms buy and manage companies before selling them, overhauling them to earn a profit. They tend to invest in mature companies rather than startups, and their investments include early-stage, high-risk ventures, usually in sectors such as software and healthcare. Private equity returns have historically outperformed public equity, and the asset class has exhibited returns similar to emerging market equities and higher than all other traditional asset classes. Private equity can also help to diversify a portfolio by mitigating public market and cyclical risk. However, it is a high-risk investment and investors are unlikely to be protected if things go wrong.

Private equity returns have historically been higher than other assets

Private equity has historically outperformed public markets across time horizons. Over the last 25 years, the Global PE Index has outperformed the MSCI World Index by more than 500 bps annualised on a net basis. Private equity funds have delivered an average annual return of 13.1% over the previous 25 years, compared to the 8.6% average return posted by the S&P 500 during the same period.

Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020. During that same time frame, the Russell 2000 Index averaged 6.69% per year, while the S&P 500 returned 5.91%.

Private equity's outperformance is due to the active role private equity investors play as owners and operators of businesses. They engage deeply with management teams to implement a focused strategy and take a long-term approach to creating value. Private equity managers directly contribute to strategy and value creation, and their influence over day-to-day decisions, strategy and operational best practices is significant.

Private equity managers are also focused on the long term. They have the patience to undertake strategies and make large investments that can take years to bear fruit. They are less concerned with quarterly results and shorter-term performance, and they are focused on helping portfolio companies achieve long-term, durable business performance.

As a result, private equity-backed companies exhibit higher growth and better margins, on average, than publicly traded firms. Private equity firms have a number of strategies to increase the value of their portfolio companies, such as dramatic cost cuts or a restructuring, or helping the company develop an e-commerce strategy, adopt new technology, or enter additional markets.

Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. However, it is important to note that private equity performance can vary significantly based on factors such as the industry, the economic climate, and the specific strategies employed by the private equity firm. Over certain periods, private equity may underperform the public stock market.

Private equity is also less accessible than the public stock market, as only accredited investors are typically permitted to invest. Additionally, private equity is less liquid than public stock investments and requires a longer time horizon.

Private equity in a portfolio helps to diversify against market and cyclical risk

Private equity funds represent an asset class that offers a lower correlation with public market movements. While economic conditions may affect the performance of portfolio companies at a fundamental level, private equity managers seek to create value over the long term by investing capital directly into private companies and then working with those companies to ensure that their capital is effectively utilised to increase value. This contrasts with public equity investments, which represent secondary transactions that will benefit more from ongoing economic growth.

Because private equity investments take a long-term approach to capitalising new businesses, developing innovative business models and restructuring distressed businesses, they tend not to have high correlations with public equity funds, making them a desirable diversifier in investment portfolios.

Private equity funds have far more control over the companies they invest in, allowing them to make more active decisions to react to market cycles, whether approaching a boom period or a recession. As a result, private equity funds are more likely to weather downturns.

Private equity funds also provide access to a larger pool of unknown opportunities that do not face the same scrutiny as public companies, as well as the resources to perform due diligence on them and identify which are worth investing in.

The stability and recurrence of cash flows leveraged from assets under management can provide a secure source of income to investors.

Private equity funds have access to a bigger pool of unknown opportunities

Private equity firms have the resources to perform due diligence on these unknown opportunities and identify which are worth investing in. They can also take an active role in the companies they invest in, from advisory and assistance to fully restructuring and running the company.

The larger private equity firms have specialised value creation teams dedicated to increasing the return on investment as much as possible in the long run. They can make active decisions to react to market cycles, whether approaching a boom period or a recession, meaning they are more likely to weather downturns.

Private equity funds are also able to mitigate the principal-agent problem. They can take control of the running of the company, ensuring that the long-term value of the company comes first, pushing up the return on investment over the life of the fund.

Private equity firms can take on active ownership

Another way private equity firms take on active ownership is by making operational and financial changes. Private equity ownership allows management to take a longer-term view and make decisions without the pressure of meeting analysts' earnings estimates or pleasing public shareholders every quarter. This enables the company to focus on increasing its value over time, which can lead to a profitable exit strategy for the private equity firm, such as a resale or initial public offering (IPO).

Private equity firms also have the ability to impose debt on the companies they acquire. This can be done by acquiring companies primarily through debt, which is later repaid using the company's cash flow or by selling its assets. While this strategy can increase the potential return for private equity firms, it can also burden the acquired company with excessive debt and increase the risk of future bankruptcy.

Overall, private equity firms' active ownership strategies aim to maximize returns for their investors by increasing the profitability and value of the companies in their portfolios.

Private equity funds have a strong alignment of interests

GPs often invest their own capital in the fund, demonstrating their commitment and confidence in its success. This alignment of interests is further reinforced by the fact that GPs typically receive a share of the profits, known as carried interest, which is tied to the fund's performance. This carried interest incentivizes GPs to make sound investment decisions and actively work to maximize returns for LPs. As a result, everyone involved is working towards a common goal of generating strong returns.

In addition to contributing their own capital, GPs also have skin in the game through the management fees they earn, which are typically set at a percentage of the fund's assets. This two-pronged approach to aligning interests helps ensure that GPs are motivated to make decisions that benefit the LPs and the fund as a whole.

The structure of private equity funds, with GPs and LPs, is designed to provide tax advantages and limit the liability of LPs. This structure also fosters a collaborative environment where GPs actively involve LPs in key decisions, ensuring that their interests are aligned. The alignment of interests in private equity funds makes it a compelling investment option, as it provides investors with the assurance that the fund managers are working towards the same goal of generating strong returns.

Furthermore, the alignment of interests between GPs and LPs in private equity funds extends beyond just financial gains. GPs are known for their active management style, where they work closely with portfolio companies to improve their operations and strategic direction. This hands-on approach benefits the LPs by potentially increasing the value of their investments and also contributes to the overall business ecosystem by revitalizing struggling businesses.

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