15 October 2021

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15 October 2021

What is Private Equity?

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Ivan Rados

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When we buy and sell shares on a public stock exchange, we are trading ownership in companies which are publicly listed. However, when discussing ownership in companies which are not publicly traded, ‘listed’ or found on any stock exchange, this is called investing in ‘Private’ Equity. It might surprise some to learn that the overall universe of private companies is significantly larger than that of publicly listed companies. For example, in the United States alone there are over 17,000 in private unlisted markets with annual revenues of more than $100 million a year compared to just 2,600 found on publicly listed exchanges like the New York Stock Exchange and Nasdaq. This illustrates that if an investor only focused exclusively on listed market companies they may be missing out on significant opportunities, industries or thematics not listed on any stock exchange.

Private Equity 1

Why investors should consider an allocation to Private Equity

It has been an observable trend in recent years that investors are increasingly turning their attention to less traditional investments with Private Equity being a key example as an alternative to traditional listed equities or fixed income. While all Private Equity opportunities are unique, the below are common characteristics often found with this asset class.

Private Equity has longer term management views

Publicly listed companies (e.g. BHP) have strict market disclosure rules which require more frequent (most often quarterly) financial performance reporting than a privately held unlisted company. Unfortunately, this can sometimes lead to management having to prioritise short term earnings objectives over longer term planning simply because it may not be popular with their investors. Often this manifests into stocks being sold off even though the management decisions might be the best thing for the long term viability of the company.

This has become an observable phenomenon and even a concern for investors. In the 1980’s, the average holding period for an equity was a healthy 9.7 years whereas today it is only about 7 months. Anyone who has owned or run their own business knows that any major planning or investment rarely ever pays off or matures in such a short time frame. Therefore, we can conclude listed markets have many more ‘speculators’ than investors today compared to 30 years ago.

Because Private Equity shares are not actively traded, they do not suffer from the short term biases that often come with listed equity investment. This allows management to be more focused on their long term objectives and are freer to focus on what is best for the company over the long term.

Private Equity 2

Illiquidity premium comes with higher expected returns

Private Equity investments cannot be readily sold on an exchange, so privately listed companies must offer investors higher compensation for this decreased liquidity. This will typically come in the form of discounted valuations upon issuance of new shares or company options and/or warrants.

Portfolio correlation benefits

Within a diversified multi-asset class portfolio, Private Equity investments offer additional benefits that often includes lower correlation with traditional stock and bond markets. The fact that Private Equity doesn’t always trade in lock step with traditional equities can be useful for investors looking to reduce portfolio volatility over the long term.

Easier (and harder) to find value

Private Equity investment opportunities are typically executed between significantly fewer competing buyers and sellers unlike listed markets where you might have millions of buyers or sellers on either side of a trade. This can make price discovery less transparent and create market significant pricing inefficiencies. It is for this reason alone that usually only skillful Private Equity investors can capitalise on opportunities as pricing can be very opaque. Without a doubt, this type of investing requires significant understanding of business valuation technical analysis. If the Investor is not directly involved with the company, it is critical that the Investor (or their advisers) have this higher level of understanding so they can determine who those more skillful managers are to put their capital with.

How investors can gain exposure

Investors can invest in Private Equity either directly via standalone deals where they invest directly in a Private Company or via Private Equity Funds. Accessing standalone deals for direct investment can be difficult for individual investors to access as business brokers representing individual companies seeking Private Equity capital will typically only engage a select number of investors, usually High Net Worth individuals, Family Offices and Private Equity Fund Managers. The most traditional way for wholesale investors to access Private Equity (and usually the most practical) is through a Fund. The investor is given access to a manager with specific skillsets and experience to pool together a series of direct Private Equity investments in one vehicle, traditionally through a unit trust called a closed end managed fund.

Private Equity 3

Most Private Equity funds are close ended

Most Private Equity Funds are unlisted and closed-ended. Unlisted meaning not offered through traditional platforms and closed ended meaning once the fund has reached its capital raise limit (i.e. $50m) it will no longer offer additional units or investment opportunities to outside investors. In addition, quite often closed end funds will mature and eventually payout all the profits and capital generated over that period of time and eventually close the fund itself. Funds will typically invest capital across various private companies in line with their investment mandate. Some Funds focus on early-stage Venture Capital providing capital to firms which are just starting out, while others provide growth capital to more mature companies who are looking to expand their operations or engage in mergers and acquisitions.

Other important considerations

Private Equity investment is best for longer term investors

Private Equity Funds typically have time frames of 5-7 years (sometimes longer if identified within the mandate) with the first few years being spent building a portfolio of companies, deploying capital in stages, with second half of the fund’s life being oriented towards aiming to sell companies for a profit typically either via IPO, trade sale or secondary buyout to other Private Equity players.

More expensive but you get what you pay for

Fees for Private Equity Funds vary and can be up to 2.0% p.a. ongoing with performance fees of up to 20.0% on Fund profits (over a watermark). Although this may seem high, it is important to understand the special nature and time intensity the fund mangers often bring to investors which may include being directly involved in supporting management, sitting on the board or assisting for future capital raisings.

 

This article contains information of a general nature only and does not take your personal circumstances into account. Please read our disclaimer which directs you to seek independent professional advice before making any decisions based on information in this article.

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