The private equity opportunity: public companies are only the tip of the iceberg

Private equity typically involves taking an ownership interest in a private business or asset. It includes a broad range of longer-term and company specific exposures which, because they are not listed on a public market, tend to exhibit somewhat lower correlation to traditional stock and bond markets. Private equity managers seek to generate superior returns through taking an active role in monitoring and advising companies through restructuring, refocusing and revitalising tactics in order to sell the investment at a profit.

There are significantly more private companies than public companies, and the number of listed companies has been steadily decreasing. Since 1996 the number of US listed companies has fallen 50%.

Private markets are significantly larger than public markets

The number of listed companies has been steadily decreasing

Source: S&P Capital IQ

Global allocations by investors to private equity have been steadily growing since 2000, increasing almost 6 times.

One of the key reasons for this is that performance has outperformed public equity across long term time horizons as well as geographic regions. The below compares private equity investments against hypothetical funds that buy and sell shares of the relevant equity index at the same time the private equity vehicles call and distribute cash.

Annualised Performance (IRR) of Private Equity versus Public Equity across Time Horizons and Geographic Regions

Source: GCM, using data from Burgiss Group and MSCI

Due diligence and monitoring

The companies invested in may involve a high degree of business and financial risk. They may be in the early stage of development, may be rapidly changing, may require additional capital to support their operations, or may be in a weak financial condition. While these are also opportunities, they clearly represent risks that need to be controlled by private equity managers.

There is also generally less information available about private companies than their listed peers. This means that investors with higher quality information are often able to make better investment decisions, and is one of the reasons performance dispersion in private equity tends to be greater than in the public markets. Extensive due diligence and careful monitoring are essential safeguards when constructing private equity portfolios.

Historically, one of the key benefits of private equity has been its somewhat lower correlation to other traditional assets and the diversification benefits this has provided at a portfolio level. The chart below shows that adding a 20% allocation of private equity to a traditional 60/40 equities/bond portfolio generated higher returns with lower risk (as measured by volatility) over the last 20 years.

There are a number of factors that have historically contributed to this strong performance. The most significant are the lack of short-term public pressure allowing for a long-term investment orientation, the historical resilience of performance across various market environments, and the illiquidity premium – investors prefer liquid investments and therefore demand an increased return on less liquid alternatives.

The unlisted and hands on nature of private equity investments suggest different risk considerations compared to public equity markets. Some risks are of course the same – economic, market, currency, political – but others differ.

Unlisted private equity investments are typically illiquid.

Private equity funds may hold securities or other assets in companies that are thinly traded or for which no market exists. Distributions tend to be irregular and depend on the sale of an underlying investment.

Third party pricing information is also not available for a large proportion of private equity assets. Valuations may therefore require discretionary determinations and in certain circumstances investors may have to rely on valuations from the underlying managers themselves.

Risk vs Return

Listed and unlisted vehicles have their own pros and cons, but the key one relating to private equity is liquidity. Unlisted funds may offer daily or monthly liquidity, however, given the illiquid nature of the underlying investments, they have the ability to restrict or freeze redemptions. Listed vehicles provide liquidity for investors who can buy and sell on market as long as an active market exists.

The private equity universe is vast, differentiated by types of companies, investment strategies, and implementation options. Private investment vehicles differ markedly across these variables and, as with listed equity vehicles, it makes good sense to have more than one in your portfolio.

Source: Pengana

To an extent, the diversification may be derived from the resilience of private equity’s historical performance across various investment environments and, in particular, periods of economic stress such as 2008’s GFC.

Private equity has been a difficult asset class to access for individual investors. However, there are now a handful of unlisted and listed funds and trusts in Australia that overcome many of the hurdles that have prevented investment in the past.