Private Equity
One possibility $CSPX (-0.31%) (S&P 500) to beat?
Private equity is a topic of great interest to many private investors. Given the great interest here on Getquin for diversification in a well-positioned portfolio, many are looking for alternatives that can deliver better results than just the stock market. This is where the central question comes into play: "How can you outperform the index?"
In this post, we will look at private equity as a potential asset class for private investors. We will look at why private equity has historically delivered high returns and what challenges and opportunities there are for private investors to enter this market.
Background knowledge
Private equity refers to investments in unlisted companies. These investments are made by private investors who inject equity into companies in order to finance their growth, restructuring or takeovers. In contrast to public equity markets, where shares in listed companies are traded, the shares in private equity investments remain in the possession of a small group of investors (usually between 100-500 investors for larger funds)
Private equity differs from other asset classes in several respects:
- Liquidity: While stocks and bonds can be traded relatively easily and quickly, private equity investments are more long-term and less liquid. Investors must be prepared to keep their capital tied up for between 7-10 years.
- Access: Access to private equity is often more restricted. While stocks and bonds are accessible to everyone, private equity investments often require high minimums and are usually reserved for institutional or UHNWI investors.
- Influence and control: Private equity investors often have significant influence over the management and strategic direction of the companies they invest in. This is in contrast to the passive investments typically found in the public markets.
Historically, private equity has generated higher returns than the public markets. Studies show that, on average, private equity funds offer a higher annualized return than traditional equity investments. This is because private equity investors can actively intervene in the management of companies and often make them more efficient and profitable (source: Deloitte). In addition, many private equity strategies aim to buy companies at a favorable time and sell them at a profit after restructuring. However, these potentially higher returns also come with higher risks and a longer capital commitment. It is therefore important to be aware of the specific challenges and opportunities of private equity before investing in this asset class.
Advantages of private equity
As mentioned above, private equity has historically generated higher returns than many traditional asset classes. These above-average returns are the result of several factors:
- Active management: Private equity investors work closely with company management teams to improve operational efficiencies, drive growth and implement strategic initiatives such as buy and build strategies.
- Focus on growth: Private equity often targets companies that are in a growth phase or whose potential has not yet been fully realized through restructuring and optimization.
- Leverage: Using debt capital to finance acquisitions can increase the return on equity, even if this also increases the risk. Before the interest rate hikes, it was still common to finance such an acquisition with 70% debt capital. However, since debt capital has become more expensive, private equity funds achieve a significantly higher proportion of returns with operational value enhancement than with the leverage effect of debt capital.
Challenges and barriers
- High minimum investment and deal sizes: One of the biggest hurdles for private investors looking to invest in private equity is the high minimum investment and large deal sizes. Many private equity funds require a minimum investment in the millions, which often makes this asset class only accessible to institutional investors or UHNWIs. These high entry barriers can deter private investors from investing directly in private equity.
- Low liquidity and long commitment periods: Private equity investments are generally long-term and illiquid. This means that investors have to tie up their capital for several years, often over a period of 7 to 10 years or longer. During this time, it is difficult to recover the invested capital as there are no regulated markets for trading private equity shares. This is referred to as the "secondaries market" which, however, is not yet very well developed, especially in Europe. This low liquidity represents a significant barrier, especially for investors who need flexible access to their capital.
- Information asymmetry and lack of transparency: Another major obstacle for private investors is the asymmetry of information and lack of transparency in the private equity industry. Private equity funds and their portfolio companies are not subject to the same disclosure and reporting requirements as listed companies. This can make it difficult for private investors to make informed investment decisions and monitor the progress of their investments. The limited availability of information increases risk and requires a high level of trust in fund managers.
Opportunities for private investors
Direct investment in private equity shares
In my opinion, the most direct and effective way for private investors to profit from private equity is to invest directly in shares of listed companies that are heavily involved in private equity. Here are the reasons why:
Funds of funds and their dual fee structure
Investment funds that invest in private equity, also known as funds of funds, often have a dual fee structure. This means that investors not only pay the fees of the fund of funds itself, but also the fees of the underlying private equity funds. This double fee burden can significantly reduce returns and makes this option less attractive for private investors.
High costs of private equity ETFs
Similar to funds of funds, private equity ETFs have high management costs. These ETFs also charge management and administration fees, which are in addition to the costs of the private equity holdings in the ETF. This results in a similar double fee structure that reduces the total return for investors. In addition, these ETFs are often more expensive than traditional equity ETFs, which further reduces their appeal. An example of this is the: $IPRV (-0.86%) with TER of 0.75%.
Specialized knowledge required for secondaries
The private equity secondary market, where shares in existing funds can be bought and sold, requires specialized knowledge and a deep understanding of the industry. Without extensive knowledge and contacts in the industry, it is risky for private investors to get involved in secondaries. The complexity and potential risks make this option impractical for most private investors.
Direct investment in shares of private equity companies as a solution
Instead, direct investment in shares of listed private equity companies offers a viable alternative. These companies are often at the forefront of the industry and offer investors the opportunity to benefit indirectly from private equity investments without the complications and high costs of other access routes. Advantages of this strategy are:
- Transparency: Listed companies are subject to strict disclosure requirements, which means more transparency and a better information base for investors.
- Liquidity: Shares can be traded on the stock exchange at any time, offering greater liquidity compared to direct private equity investments.
- Easy accessibility: Buying shares does not require a high minimum investment or specialized knowledge, making it easy for private investors to invest
Examples of listed private equity companies:
- $BX (-0.65%)
: As one of the world's largest private equity investors, Blackstone offers access to a diversified portfolio of investments. - $KKR (-1.5%)
: Another leading player in the private equity industry with a strong track record and global investments. - $CG (-0.45%)
: A globally active private equity firm with extensive holdings in a variety of sectors.
By investing directly in these shares, private investors can benefit from the potential returns of the private equity industry without the disadvantages and complexities of traditional access routes. However, it is important to note that as an ordinary shareholder you are at the bottom of the food chain and private equity managers are paid their excess returns through a so-called "carry". This carry is the reason why private equity managers are paid more than handsomely.
Conclusion
Private equity offers private investors an interesting opportunity for portfolio diversification and potentially higher returns. Despite impressive results, high minimum investments, low liquidity and information asymmetry are significant barriers.
Direct investments in shares of listed private equity companies offer a viable alternative. These shares offer transparency, better liquidity and do not require high minimums. However, investors should note that as shareholders they do not receive the same returns as private equity managers who receive high levels of remuneration through carry.
Private investors should carefully consider how private equity fits into their investment strategy, conduct thorough due diligence and understand the specific risks and rewards in order to make informed decisions and successfully diversify their portfolio.
