The modern private equity fund was invented and polished in the 1960s and 1970s in the USA. This asset class comprises venture, growth, and mezzanine capital, leveraged buyouts, and distressed debt. Their emergence was possible because the limited partnership structure could be used to create funds; but also because pension funds, in addition to family offices and a few rich individuals, could start to invest in private equity funds in 1979, after the change in the interpretation of the “prudent man” rule of ERISA (the Employee Retirement Income Security Act of 1974). The private equity niche started to develop after that, but it was still a rather boutique-like industry, very local, and mostly American. Then starting in the 1990s, a massive influx of capital drove this niche to the status of a full-grown asset class — growing from roughly $10 billion under management in 1990 to roughly $3,000 billion in 2012, according to Preqin.
The reason for that influx of capital is of course the thirst for yields. As marginal returns tended to decrease on the stock exchange, as bonds yields decreased too, investors grew more sophisticated and looked for alternative strategies. This was not only to diversify or hedge their risks, but also to get exposure to emerging segments of the economy (new sectors, emerging companies, emerging geographies) that private equity could offer.
So today, the industry has reached a certain maturity, and the risks associated with private equity are better known. However, and interestingly, the historical returns of over 20 percent in the 1980s are no longer assured, as the average net return for investors now is in the region of 12 percent. That is far higher than the average net return of hedge funds, and even more so than ETFs, tracking stocks, or bonds, but it is a lot less than it used to be.
Today, 60 percent of the investment activity remains American. Europe represents about 25 to 30 percent. That leaves small amounts for other areas such as Japan, Australia, South Africa, Israel, and emerging markets. Keep in mind that these numbers are educated guesses, as statistics are very patchy and mostly reflect the activity of fund managers. A lot of private equity activity by family offices, rich individuals, corporations, and private organizations has gone uncounted.
There are between 4,000 and 5,000 private equity fund managers worldwide that are more or less known. Because there is no “Bloomberg of private equity,” we are kept in the dark about the real dynamics of the sector. Most famous in the mega-LBO world are the (now) public firms: Blackstone, Kohlberg Kravis Roberts, Carlyle, Apollo. These happen to have been listed recently, notably because (a) their ambition is to become the merchant banks of the XXIst century, and (b) to handle succession issues at their helm. In middle/small LBO, we have a flock of very local players that are too numerous to list. In venture and growth capital, the big names are of course Sequoia Capital (Google, Yahoo!, Amazon, Cisco, etc.), Kleiner Perkins Caufield & Buyers, Index Ventures, and quite a few others. Once again, this is a very local market.
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 non-listed companies. It requires a lot of know-how in finding the opportunities, assessing them, negotiating (a shareholder’s agreement, for example), then 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. This is why, even if there are opportunities for retail investors to go into private equity (for example via crowdfunding), I believe that accredited investors are better off investing with professional managers: not only there are mechanisms to lower the average impact of the fees, but the security associated with a professional management is paramount when handling high-risk, high-return investments.
Accredited investors can gain access to the performance statistics of fund managers, some of whom have very long track records (10, 20, and sometimes 30 years of experience). 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. This is a self-reinforcing mechanism which is unique to private equity, because this asset class demonstrates unique features. That is, fund managers’ success in other asset classes aren’t as “persistent.”
A successful PE fund should provide risk-adjusted returns in the high teens. Fund managers typically draw a management fee of 2 percent of fund assets, plus they earn 20 percent of profits as carried interest. Most PE funds are closed-end funds with a 10-year lifespan. That means investors are locked into 10 years, with the returns flowing in the later years. A PE fund is a blind pool, i.e., investors have little or no control over fund managers’ investment decisions. PE is commonly around 7 to 10 percent of any institutional investment portfolio.
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 who is the investor and what is his or her strategy.
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, I would also emphasize one thing: financial assets are more or less liquid, not liquid or illiquid. It is an illusion to assume that listed assets are liquid. For one thing, 80 percent of them are barely traded; and for another thing, their liquidity can fall dramatically in a crisis context. In my business, we always assume that assets have a certain level of liquidity, not a yes/no choice when assessing their liquidity.
If we keep in mind that assets are more or less liquid, then we will agree also that prices and returns will vary with the liquidity. It is reasonable to expect that you would be rewarded for accepting less liquidity with a lower price and/or higher return.
As soon as we agree on that, the framework radically changes, and we could even state that private equity is less risky (because it’s less volatile, better monitored and controlled, and overall better managed) than listed assets. This is a radical statement, but I stand by it.
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Cyril Demaria specializes in private equity and combines practical and entrepreneurial experience, academic knowledge and lecturing experience. He is Head of Private Markets at Wellershoff & Partners, where he focuses on top-down buy-side research and advisory. Previously, he was Executive Director in charge of private markets research at the Chief Investment Office of UBS Wealth…
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