Research Update: Opportunities in Private Equity
In managing client portfolios, we focus on finding opportunities for long-term growth, while also keeping an eye on shorter-term risk. In seeking long-term growth, we focus on strategies that invest in companies whose earnings and valuations are expected to increase over time. These investments are often in companies that trade on the public stock market exchanges, but they can also be made in privately held companies. We have found that carefully chosen private equity (PE) investments can add meaningful value to a diversified portfolio. Further, we consider our ability to identify PE investments to be an important value we add for our clients, where suitable, and in this piece we set out to demystify the space and explain how and why we selectively use PE.
Venture and growth capital strategies seek companies with potential to transform an industry.
To some, the term “private equity” may suggest a realm of exotic early-stage investments or aggressive restructuring from corporate raiders that bring high levels of risk and potential reward to elite investors. While there are a range of PE strategies employed, and we’ll walk through them briefly in a bit, a helpful foundation in understanding the space and the opportunity it affords is to start with the term itself. Private equity simply refers to equity ownership in private rather than publicly traded companies.
When it comes to raising capital to finance expansion or other objectives, companies can borrow money or sell a portion of their stock. Borrowing entails risk because the financial burden of debt payments can damage or bankrupt a business if it encounters a severe downturn. By selling stock, a company can raise capital to fund expansion or a turnaround – or to allow existing owners to exit the business – without the risk to the business that debt brings. (However, the “cost” of equity, in the form of dilution to existing owners, is significant as well, and at times can be prohibitive.)
While going public through an initial public offering (IPO) can create access to the large amounts of capital available in the public markets, it comes at a cost of a heavy regulatory burden and excessive investor focus on short-term earnings. For these reasons, over the past two decades more private firms have opted to stay private, raising capital from various private market investors including venture capital (VC) and growth equity funds rather than go public. In fact, the number of publicly traded U.S. companies has dropped by almost half since the late 90s and the investable universe of private companies is now significantly larger.
Investing in PE is done through private investment funds that are offered and managed by firms with expertise in specific industries and strategies. These funds are often structured as Limited Partnerships (LPs) in which the PE managers are the General Partners (GPs) who are responsible for investing the fund’s assets and managing the overall fund, and Limited Partners (LPs) provide the bulk of the capital but are passive and have no involvement in the fund’s operations. GPs typically look to build teams with strong networks within specific industries that can help identify attractive opportunities and provide a source for operational experts and consultants that can help improve a portfolio company’s performance. GPs sometimes even place their own “operating partners” inside portfolio companies to help accelerate improvements.
The time horizon for typical PE funds is lengthy – usually 10+ year terms – and during that period there is little opportunity for liquidity. An investment in a PE fund involves a total dollar commitment that is invested in increments (over time) when the GP makes “capital calls” to the investors as needed to fund the investments it identifies.
PE funds generally have high minimum investments ($5 million and up), and there are regulations that usually restrict investment in these funds to Qualified Purchasers (QP). Qualified Purchasers are sophisticated investors that meet minimums around total investable assets, annual income, and/or investment experience.
The limitation on eligibility to invest in private equity isn’t an issue for most of our clients; rather, the more difficult issue for incorporating PE into our clients’ portfolios has been the high required investment minimums for many of these funds. For example, some PE vehicles have a minimum of $1 million (and most established firms now have minimums higher than this), which can be more than an investor would like to allocate to just one PE fund. Further, this high minimum can make it challenging to implement an appropriate allocation to PE within a portfolio. For example, an investor with a maximum desired allocation of 10% would require a total portfolio value of $10 million (and this example doesn’t provide for the diversification we would like to see within an allocation to PE – see more on that below).
One of the reasons for high minimums has been the high operational complexity and cost involved in administering PE vehicles, which include complex accounting, capital calls, etc. that can make it uneconomical for PE vehicles to take smaller investments. And if the investment opportunities that meet their criteria are finite and they are easily able to attract investors – as is the case for many established PE firms with long and successful records – there is no incentive to take on smaller investors.
Increasing availability of high-quality, lower-minimum fund-of-funds expands the ability to include PE in diversified portfolios
Fortunately, in recent years there have been increasingly more fund-of-fund vehicles offered by PE investors we believe to be highly skilled and who – through a combination of technology and broader distribution – are able to offer high-quality underlying PE investments at more accessible minimums in the six- rather than seven- or even eight-figure range. Additionally, they provide more diversification among PE investments, which is also important. This in turn broadens the profile of clients where we feel confident including PE in their portfolios.
Of course, there are other important factors in allocating to PE, including time horizon, liquidity requirements, risk tolerance, etc. and all of these are taken into account in our guidance to clients as to whether or not we recommend including PE in their portfolios. But for those where it makes sense, PE brings a number of advantages relative to the liquid stocks and bonds we use to build client portfolios.
Potential Benefits of Private Equity
- Large investment universe. The number of private companies far exceeds that of public companies, and many companies are staying private longer, which provides more of the growth opportunity to private investors.
- Longer time horizon with which to add value. PE managers can help smaller companies in particular improve operations and pursue new opportunities that have a high likelihood of paying off over a multi-year horizon. This leads to the next point, which is…
- Less distractions relative to public companies. Management teams can focus on running and growing their businesses without the short-term pressure of earnings calls and incentives that many public companies face.
- Strong alignment between company management teams, PE managers, and investors.
- Inefficient information flow. Public markets have a very level playing field in terms of disclosure that reduces an investor’s ability to gain an information edge over other investors. However, in the private space a skilled PE management team with strong industry knowledge can potentially uncover unrecognized opportunities.
- Ability for GPs to add value. The same network and expertise that allows GPs to source attractive deals can also help them bring value to the companies they own through operational improvements, restructuring, uncovering new growth opportunities, creating scale through add-on acquisitions, etc.
- Diversification. PE funds and their underlying investments are significantly affected by unique factors connected to their particular business versus broader stock or bond market dynamics. That’s not to say they are immune to the broader business environment, but attributes like where they are in their lifecycle, development of innovative and sometimes transformative products, and highly specific business challenges and opportunities, for example, result in very different return drivers for PE funds, which creates a diversification benefit when added to a portfolio that includes public equities.
- Consistent long-term track record of outperformance versus public equities. Individual PE investments can be highly risky, and PE fund returns can be negative early on as capital is deployed that will take time to generate a benefit (and fees are paid), before turning positive as improvements are realized (the performance pattern is described as a “J-curve”). But at an aggregate level the performance realized in PE has been better than that of public equities over the long term.
The potential advantages of PE can vary widely depending on what types of strategies are employed and how skilled the PE management team is.
Investment Strategies Employed by PE Funds
Buyout is the largest PE category and typically involves taking a controlling interest in a company and employing strategies such as restructuring to improve its growth and profitability. This can involve a private company or a public company that is then taken private. Buyout managers typically look for somewhat more mature, stable companies and use leverage to varying degrees to enhance returns.
Growth capital is also a large category and usually involves buying equity in a private firm with an established business that needs capital for growth or acquisitions. These are usually minority investments where the interests of company management and the PE investors are strongly aligned. Because these companies are typically still experiencing high growth, little if any leverage is used for growth capital investments.
Venture capital (VC) is also a significant category and involves early-stage investments in companies that can be highly innovative and/or disruptive to existing industries (think Uber versus traditional taxi companies). These companies generally carry the highest risk and the highest potential for reward. The VC model relies on a few massive winners in each fund returning multiples of their initial investment to generate performance, overcoming the higher number of companies that produce negative returns (with many being written off entirely).
Distressed involves equity or debt investments in companies facing significant financial or operational challenges that the PE manager believes can be turned around including through restructuring, often after gaining control via the debt through a bankruptcy process.
Secondaries are typically the sales of an existing interest in a PE fund to another investor, usually at a discount that reflects the lack of liquidity. This could happen if an institution becomes overallocated after public markets decline sharply, but has in recent years become more common as a standard way for LPs to manage their PE portfolio for a variety of reasons (e.g., trimming the number of non-core GP relationships). Related to this is a more recent trend where PE managers raise capital from secondary investors to create a new vehicle to hold on to investments they believe still present significant growth opportunity but where the original fund is nearing the end of its planned life. Finally, secondaries can be interests in individual companies, where an owner of private stock wants to sell a portion to raise cash for another purpose. This could be an employee of a private company needing cash and not being willing or able to wait for the IPO.
How We Use PE Investments within Diversified Portfolios
Given the lengthy commitment period, lack of liquidity and high levels of volatility and risk, successfully investing in PE requires a strong research focus and careful consideration when and how to include PE in a more broadly diversified portfolio. Our research team (through our affiliation with iMGP) has expertise in identifying and completing due diligence on suitable PE investments, and we have a clear approach for how we include PE in our client portfolios.
Client suitability is critical and is always the starting point. What does that mean? Risk tolerance is part of it, but it’s more than just the degree to which someone is uncomfortable with volatility or the idea of more speculative investing. Of course we have to consider their comfort with this style of investment, but even more important is a client’s overall financial position relative to their goals.
Suitability is based on a client’s risk tolerance, time horizon and liquidity needs
A client with multiples of capital more than they require for financial security can make longer-term and potentially riskier or more speculative investments without as much concern for unexpectedly needing liquidity or for the impact that an unforeseen investment downturn or setback can have on their lifestyle. A client with a high likelihood of achieving their financial objectives in the future but less margin for error may not want or need to complicate that by owning something with higher volatility and low liquidity, as it could create some potential for disrupting their broader objectives. Wherever a client falls on this spectrum we carefully consider their full financial circumstances to determine whether an allocation to PE makes sense, and if so to determine the appropriate size of an allocation to PE for their portfolio.
Turning to portfolio construction, any addition to an already-diversified portfolio includes determining which existing investments it will replace. We consider PE to be a part of our “alternatives” category, which refers to investments with different risk and return drivers than the more traditional (and publicly traded) stocks and bonds that serve as core portfolio building blocks. Alternatives are selected to reduce overall portfolio volatility and, depending on the investment, to also reduce downside risk or increase upside return potential – and in some cases both – relative to the investments they replace.
In the case of PE, given its typically more aggressive risk profile, it generally replaces public equities (stocks) one-for-one in our client portfolios (though this can vary depending on the types of strategies included in each PE fund, as well as other factors). For these portfolios, owning both public and private equities, in the appropriate proportion better balances important objectives like liquidity, risk and return than can be achieved by owning either alone.
Looking specifically at the PE investments themselves, we believe it is critical to diversify across multiple criteria. First, we want to diversify our client’s positions with several PE managers to increase the potential to capture returns from different managers who cover different styles, areas of expertise, and types of opportunities. Strategy diversification is important because over the long duration of a PE fund, business and economic trends can emerge that have significant impact (good or bad) on particular strategies. And, we prefer to have our clients use multiple vintages – which refers to the year in which a PE fund is launched or begins making investments. Through these vintages we can improve diversification to mitigate the risk of broad business cycles hurting performance, and take advantage of different timing on new investment opportunities, both of which are impacted by the entry and exit point of fund investments.
Achieving suitable diversification is done more easily in larger overall portfolios, because the underlying PE funds have relatively high investment minimums, that must be met without resulting in a client’s overall PE allocation exceeding the target percentage. Fortunately, we have been able to identify high quality PE funds-of-funds with built-in diversification among investments and managers, offered at modest investment minimums with very reasonable fees relative to the quality of underlying GPs. These are mostly in the buyout and growth capital areas. PE investment areas like distressed and special situations can also be included during periods when opportunities are compelling, and we can include venture capital based on availability of high-quality options.
In Closing…
Through in-depth due diligence that identifies high quality investment vehicles offering potential for long-term capital growth, attractive diversification and lower minimums, we have found effective ways for our clients to take advantage of PE investments. We are happy to share more about this investment area and the long-term portfolio benefits that we believe come from the inclusion of private equity in an investment portfolio.
If you have questions or want to discuss this opportunity with your advisor, please don’t hesitate to reach out.