Understanding Private Equity

As public equity markets continue to flirt with all-time highs on a daily basis, and with the expectation that one of the longest sustained bull markets in history may be coming to an end based on late market cycle indicators, many investors are turning to alternative investment opportunities to drive value and growth generation in their overall portfolios.  While real estate, commodities, and even niche public market sectors may still have upside left to be gained, very few investments have the long-term track record of sustained growth that characterizes the private equity markets.  Particularly given the growing demand from companies seeking private capital infusions, we believe now is an ideal time for investors to consider how these types of investments can enhance the overall value and potential stability.


What is Private Equity?

A simple definition of private equity: shares representing ownership or interest in an underlying entity that is not publicly listed or traded on an exchange.  Typically, companies seeking private equity infusions are smaller in size and scope than public companies, and therefore find it more difficult to obtain funding from banks and traditional investors.  Similarly, younger companies are good candidates for private equity investments as they typically encounter a number of financial hurdles unique to the start-up and early growth phases of their respective businesses.  From the perspective of the underlying company, private equity investments are a critical source of capital to help fund growth initiatives, acquisition strategies, and general operations.  In exchange, private equity investors typically require a higher ownership stake for their contributions, thus enabling them to have more control over the operations and long-term growth strategies of the underlying company.

Historically, these types of investments have been reserved for high-net-worth individuals capable of making large financial contributions, typically in the seven-figure range.  However, with the decline of pension funds and similar large investment pools, private equity funds have increasingly made these opportunities more accessible to the individual investor.  While those interested in accessing private equity investments must still qualify as an accredited investor*, minimum investment amounts have dropped significantly over the last several years and the need to have resources for additional capital calls is no longer an additional hurdle.

*An accredited investor is someone with a net worth of $1,000,000+ (excluding primary residence) or an annual income of $200,000 for an individual, $300,000 if married.

How Private Equity Creates Value?

Most people have a pretty firm understanding of how public equity creates value.  Someone interested in acquiring shares of a publicly traded company can do so by finding out the prevailing market price and ticker symbol for said company and making a purchase through one of the public exchanges.  The subsequent value provided from public equity securities is generated by price appreciation of the underlying stock and dividends (if applicable).  Due to the volatile nature of the public stock market, these purchases of public stock ownership should be handled with care and executed with the help of a knowledgeable financial advisor.

Private equity is similar in that the purchaser is attempting to obtain an ownership share of an underlying company (or group of companies).  However, unlike public equity, these securities are not listed on public exchanges.  As such, value generation occurs through alternative means.  To better understand how private equity funds generate value for their investors, it is helpful to examine the process by which they engage and source opportunities.  While there are a number of nuanced methods firms utilize to derive value for their investors, the following example is by far the most common approach.

For the most part, Private Equity (PE) firms look for companies with significant growth potential that, due to a lack of resources or business expertise, are unable to achieve full upside potential on their own.  Once a suitable candidate has been identified, the PE firm makes an offer to acquire said company with funds it has raised separately from individual accredited investors.  Post-acquisition, the PE firm goes to work on improving the newly acquired company wherever necessary.  Often times they will insert experienced management teams into the business to uncover operational efficiencies and identify previously underutilized strategies for sustainable growth.  Other times, an acquisition may be used to enhance the value of an existing larger company the PE firm already owns.  In these instances, value generation is achieved through creating synergies and economies of scale at the larger entity.  In either case, the goal is to create previously unrealized value from the underlying company it has acquired. Once the PE firm believes they have maximized the value of the underlying company, they will look to exit the relationship by taking the company public or selling to another private investor.  Although value is being returned to investors throughout the life cycle of the investment, a significant amount of ROI is derived from the exit strategy.

The typical time horizon for this type of investment, from the initial capital raise to exit strategy implementation is 5-7 years.  As such, private equity plays are considered long-term investments, and usually require investors to commit their initial investment for a minimum of 6 months to 1 year before withdrawing their funds.  Therefore, in addition to qualifying as an accredited investor, it is important for those interested in private equity to consider their short-term liquidity needs alongside their other investment strategies.

 

Private Equity Return Characteristics

Now that we understand how private equity investments work, let’s take a look at their potential returns.  As a reminder, past performance should not be considered an indication of future results.   That said, the historical track record of top-quartile private equity fund managers (top 25%) is rather compelling and can provide some context for comparison with traditional public markets.

According to Cambridge Associates**, US Private Equity Index and benchmark statistics, through December 2015, the top 25% of PE firms have produced positive double-digit returns every year since 1986.  This is particularly impressive given that this timeframe includes periods of significant declines in public markets, such as the recession of 2008 and the tech bubble of the late 90’s and early 2000’s.  While it’s true that public equity has outperformed private equity at during certain market cycles, especially in years of significant public market growth, the consistency of private equity investment returns has enabled some investors to buoy their portfolios during recessions.  While public equity stock prices are susceptible to market sentiment, private equity investments derive value exclusively from profits of the underlying assets, and/or through the eventual sale of those entities.  For example, during the financial crisis of 2008 the S&P 500 was down more than 30% from peak to trough.  The top-quartile private equity managers however generated returns in excess of 20% on behalf of their investors.  While it is unwise to base investment decisions purely on past performance, the underlying nature of how private equity can create value for investors provides a tool for diversification away from the volatility of public markets and becomes manager risk versus market risk.  We anticipate this will be particularly important for investors over the next couple years when public equities are expected to experience a cooling off period as late market cycle trends continue to emerge.

**Data derived from Cambridge Associates’ Private Investments Database, a highly regarded representation of institutional quality private fund performance, and reflects 1,358 US private equity funds, including fully liquidated partnerships, formed between 1986 and 2015.  Cambridge utilizes quarterly unaudited and annual audited fund financial statements produced by fund managers for their Limited Partners.  Data is elf-reported and thus may be subject to inherent limitations. 

Conclusion

While it’s true that private equity investing isn’t for everyone, we believe there are advantages for accredited investors who are looking to reduce their exposure to public market risk while still striving for long-term growth expectations.  When selecting the appropriate private equity investment, we encourage clients to pursue managers in the upper quartile of the industry.  Additionally, we believe identifying the underlying investment strategy of a particular private equity fund is extremely important, as different sector risk can be more favorable than others depending on prevailing economic conditions at any given time.  If you are interested in learning more about private equity, a fiduciary advisor can help provide an independent assessment of existing opportunities, as well as help you determine the exposure you should have to this type of alternative investment strategy.

 

Disclosures

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Past performance is not indicative of future results. Integrity Financial is an independent investment advisor registered with the U.S. Securities and Exchange Commission under the Investment Advisor Act of 1940, as amended. More information about Integrity including its investment strategies, fees, and investment personnel can be found in its Form ADV Part 2, which is available upon request by email [email protected]