The investment management industry is constantly changing, finding new ways to provide adequate or even superior returns. Traditionally, investors rely on equities and bonds (debt) as the sole source of returns. However, low interest rates and market volatility have created the desire for alternative opportunities. Enter alternative assets. According to Prequin, this sector was worth $10 trillion in 2019 and is expected to grow to $14 trillion by 2023 1.

A significant proportion of the alternative asset class sector is private equity. In fact, private equity is expected to overtake hedge funds as the largest alternative asset class 1. Prequin’s survey containing 300 fund managers and 120 institutional investors revealed their appetite for private equity investing. 79% plan to increase investment into the private equity sphere which, in 2019, was worth $3.9 trillion – 12.2% growth from the previous year 2.

Why are investors becoming ever more desiring of private equity investments? The returns of this sector expose one of the reasons behind its increasingly appealing lure. Comparing it to the returns of the FTSE 100, it is easy to see why investors are flooding to the alternative asset.

3 Bain & Co; Public vs Private Equity Report 2020

Most impressively perhaps, is private equity’s returns during recessions. In both cases above, private equity has outperformed and retained positive returns compared to the equity market (“Buyout funds” refers to private equity houses) on top its general outperformance.

But what is private equity and how does it generate such ample returns?

Private Equity and Its Returns

Private equity is capital invested in the private markets. Funded by capital from investors into private equity funds, firms invest directly into private companies or engage in buyouts (purchasing all of a public company’s shares and removing it from the stock market). Similar to investment managers, private equity has both passive and active investors, although the two usually combine together when making purchases. Passive investors are merely a source of capital, but active investors take a more invested approach and actively make changes in the purchased companies to drive the returns.

I think the best explanation of how private equity firms generate profit is Blackstone Private Equity’s slogan, ‘Buy it, fix it, sell it’ which in essence, is the framework of the sector. As with most things in life, this simple sounding objective is difficult to achieve.

The target investments of these firms fall into two categories. The first: undervalued companies. These may be distressed businesses undergoing turbulent times or ones which have been poorly managed. The market for their ownership is lower than what a potentially fair valuation would suggest, and its true value is not yet realised. The role of the private equity firm here is to assist the company in realising this true value. Using its experience and expertise, the private equity house can drive growth in the business. The usual tactic employed is to implement operational changes like improvement in supply-chains or other general advice but sometimes they use more aggressive tactics. It is not uncommon for the buyout firms to simply replace the existing management if they are deemed unsuitable.

The second kind of target includes businesses with tremendous growth opportunities which have not been reflected in its current price. Although seemingly in shareholder’s interests, aggressive growth strategies by management can be difficult to implement under the control of shareholders whose interests lie in the valuation of their assets. Dividend cuts may be necessary to fund future investments yet, in the eyes of the market, this can symbolise a weaker company and in turn, reduce the value of shareholders’ investments. Private firms with their concentrated ownership are not burdened by this and can take advantage of the more patient, long-term view of buyout firms.

Whether a company has been bought due to its undervaluation or its potential growth opportunities, the outcome remains the same – purchase a business below the just long-term price, implement structural changes and sell the now higher market-valued company, either to other private investors or publicly through an IPO.

Characteristics of PE Investments

The nature of private equity means investments share common underlying characteristics which differentiate it from traditional, public investing. Building up companies takes time. As a result, private equity investments have long investment horizons with typical investments spanning between 5-10 years. For example, supply-chain systems or additional growth investments do not provide instant returns.

The long-term nature of these implementations leads to another aspect of private equity – relatively illiquid investments compared to those traded publicly. The 5-10-year horizon for returns means investments in private equity funds are rarely traded before ‘expiry’. The result – investors must usually wait for the buyout firm’s exit before they yield any return.

Unlike public markets, where shares of companies are bought and sold for fractions of the total enterprises, the nature of private equity means the upfront cost of investments equate to that of the total target company. Consequently, these investments often lie in the billions of dollars and create impressive news headlines as a result of their size. How can an investor gain exposure to private equity?

Types of Investors

Unfortunately for the average investor, private equity is a relatively difficult industry to enter. The large upfront investment means buyout firms only accept investment from large institutional investors such as pension funds, or high net worth individuals through their family offices. This is usually coupled with a significantly high minimum investment into their fund which excludes most individuals from being able to partake.

All is not lost for the individual investor, keen to have a finger in the fruitful private equity pie, however. The shares of private equity firms like Blackstone (NYSE: BX) can be bought on stock exchanges if individuals want to taste some of the private equity profits. Alternatively individual investors can invest in “funds-of-funds”. These provide exposure to many funds at once but often come strapped with bigger management fees. Is private equity the answer to modern institutional investment challenges?

Pros and Cons

One of the most clear and obvious benefits of investing in private equity is the far superior returns over public markets. Successful private equity investing can be extremely fruitful for both the firm and its investors alike, and this has been demonstrated consistently throughout its past.

Another, usually overlooked benefit of private equity, is the additional diversification an investor can gain. Diversification has long been the golden ticket to reducing unnecessary risk. Investments in private equity can help spread an investor’s capital across different asset classes.

Another point worth noting for investors, is private equity houses can choose their exit. By this I mean private equity houses have to ability to decide when they sell a business. When markets are low, a private equity houses can sit on their investment until the market becomes sufficiently inflated to warrant the sale of their asset. This why IPOs are most common during high markets, where confidence and expectations are high.

Unfortunately, like many things in finance, private equity has its drawbacks. The first has been mentioned earlier, which is the extremely high barriers to entry due to the initial upfront cost required which prevents the majority of investors from gaining true exposure to the industry.

Another drawback is the J-curve effect 4 which private equity returns often reflect. The J-curve refers to the pattern of returns which are often negative in the earlier years of projects due to payment of fees and start-up costs. Returns only become positive as the investment matures and the book value of the company catches up to the capital invested.

Private equity investing is certainly not for impatient investors looking to make a quick return. It’s about waiting and allowing fundamental changes to mature and build the value of companies from the inside rather than exploiting temporary higher prices. As a result, these transactions have long investment horizons which can lock up capital for years.

Example of a Private Equity Transaction

A deal which demonstrates perfectly the role and aims of private equity houses is Blackstone’s investment in Merlin Entertainment. In 2005, Blackstone invested $50 million into a company which had 6 million yearly visitors over 28 European attractions. By the end of the investment’s maturity in 2012, Merlin Entertainment had grown exponentially, led by Blackstone’s private equity team. With 54 million worldwide visitors and 12 large theme parks and 99 attractions, Merlin was ready to be sold. In November 2013 the IPO raised $1.5 billion valuing Blackstone’s initial equity investment at over $2 billion 5 generating an IRR of over 30%.

More recently, in November (Nov 2019) Blackstone have once again bought out Merlin. Clearly, they have seen opportunities to grow the business which could not be achieved whilst the company was public – look out for new developments in the future with this company.

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