Most people are familiar with the concept of a stock exchange and publicly traded shares of companies listed there. But the private equity market is less understood, perhaps because it is dominated by deep-pocketed institutional players like pension funds. But accredited investors may also buy private equities—essentially, shares of companies that are unlisted—by investing in a private equity fund. Direct investments are made in companies, often with an intention of gaining control and influencing their management.
The modern private equity fund was invented in the 1960s and 1970s in the USA. This asset class comprises venture, growth and mezzanine capital, leveraged buyouts and distressed debt. The private equity niche started to develop soon after, and a surge of capital in the 1990s drove this niche to the status of a full-grown asset class.
The reason for that influx of capital is of course the thirst for yields. As bond yields and marginal returns on the stock exchange decreased, investors grew more sophisticated and looked for alternative strategies. Private equity was a way to diversify and get exposure to emerging markets and geographies.
So today, the industry has reached a certain maturity, and the risks associated with private equity are better known. However, the historical returns of over 20% in the 1980s are no longer assured, as the average net return for investors now is in the region of 12%. However, private equity still outperforms the public market (e.g., the S&P 500), though not as much as it did before the financial crisis. So, should you invest through a private equity firm, and if so, how?
Investing in a private equity fund is a long-term commitment, often lasting nearly a decade. That means that it could take a while to see returns or to even quantify their value. Investors have to consider several factors, such as illiquidity, fund manager expertise and fees before taking the plunge. Nonetheless, private equity firms can help you yield high returns.
By 2025, PE assets under management are expected to reach $5.8 trillion, according to a study by Deloitte. As the global economy recovers from COVID-19, PE continues its momentum. Portfolio companies benefited from firms’ quick action and expertise during the pandemic, and the market remained resilient overall.
Research by S&P Global finds that despite the pandemic, there is still a “bullish” outlook among PE investors—especially in the APAC (Asia Pacific) region. PE investors continue to target healthcare, information technology and the consumer sector.
The US and China still produce the majority of start-ups valued over $1 billion (a.k.a. unicorns), with Beijing leading San Francisco in total unicorns. The United Kingdom comes in third by a long distance. Venture capital continues to break funding records, and experts warn that this bubble may soon burst due to a saturated market, higher investments and fewer viable exit opportunities.
These global statistics also imply a growing importance on choosing an experienced fund manager that can predict industry trends and put value into investments.
There are between 4,000 and 5,000 known private equity fund managers worldwide. There is no “Bloomberg of private equity,” so we don’t know the real dynamics of the sector, but we do know the main players.
The most successful PE firms in 2021 include:
In venture and growth capital, these are the current big names:
Why would an accredited investor go into a private equity fund, rather than a “one-off” deal to acquire a company where yields are potentially highest? Because it is still a very tough job to invest directly in private companies. It requires a lot of know-how in finding the opportunities, assessing them, negotiating (e.g., a shareholder’s agreement), monitoring the investments and steering them as the company evolves. Then, of course, selling companies requires a great deal of contacts and M&A expertise.
Accredited investors are better off investing with professional managers through a fund. A PE fund that is properly managed will maximize returns through the expertise of the manager and often additional business experts that manage aspects of the company. These professionals are vital to handling high-risk, high-return investments.
Accredited investors can gain access to the performance statistics of fund managers, some of whom have decades-long track records. We have a lot of documentation about the persistence of individual managers’ returns in private equity, which means—unlike in most asset classes—PE managers’ past performance is a good predictor of future performance. Fund managers’ success in other asset classes aren’t as “persistent.”
Other elements in the selection of a fund manager are the composition of the management team and their past performance, their strategy, their geographical location, and a set of additional qualitative and quantitative factors. Choosing a suitable fund manager actually depends a lot on the investor and their strategy.
Finally, it is important to understand the dynamic between General Partners and Limited Partners, or fund managers and investors, respectively. For example, immediately after the 2008 recession, GPs struggled to raise capital from hesitant institutional funds, giving LPs greater leverage and more favorable terms. For the most part, this relationship has balanced out once again, but economic conditions can quickly change negotiating leverage.
We hear that investing in private equity is risky because of the lack of liquidity at both the fund level and the portfolio company level. However, financial assets should be perceived as more or less liquid, rather than liquid or illiquid. It is an illusion to assume that listed assets are liquid. Eighty percent of them are barely traded, and their liquidity can fall dramatically in a crisis context.
If we keep in mind that assets are more or less liquid, then we will also agree that prices and returns will vary with the liquidity. It is reasonable to expect that you would be rewarded for accepting less immediate access to your capital with a lower price and/or higher return.
It should also be said that private equity funds are less risky than hedge funds. Illiquidity and long-term commitment may seem like downsides to some investors, but these characteristics also make PE funds slightly safer. Hedge funds, in contrast, use riskier methods to get immediate returns.
It can be argued that private equity is less risky, because it’s less volatile, better monitored and better managed than listed assets. Some may find this a radical notion, but I stand by it.
©All Rights Reserved. August, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
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