In this article we address one of the essential questions for professional investors. What is Private Equity and why we believe that investing in Private Equity (PE) funds can improve their returns.
Private Equity includes, by definition, all privately owned companies, i.e. those that are not publicly listed. Private Equity funds are a subsegment of this universe. The total size of the PE fund market is estimated at USD 15 000 bn (Preqin, June 23). Furthermore, there are a number of different strategies that the managers implement. Below is one commonly used classification.
| Type | Description and attributes |
|---|---|
| Buyout | Established companies typically with a controlling interest; capital appreciation as primary objective |
| Growth | Seeking the next major growth opportunities. Often early in a company’s life cycle; capital appreciation as primary objective |
| Opportunistic | Investing across a range of asset classes, sectors, industries, geographies and places in the capital structure. Typically, preferred and structured equity investments, asset purchases or contractual arrangements seeking yield with a focus on downside protection and less volatile returns |
| Secondaries | Negotiated purchase of existing private equity fund stakes often at a discount to fair value; typically offer a shorter period of time till return of capital compared to primary private equity |
| Venture capital | Financing provided to startup companies and small businesses that are believed to have long-term growth potential, often provided as early and seed-round funding |
With this background in mind, we can begin to address the question.
The short answer to the question “why invest” is that it can result in better investment returns and increases diversification. If one does not participate in the unlisted market, essentially PE funds, they exclude the majority of companies from their addressable investment universe. The graph below illustrates the distribution of companies with over $250 million in revenue between publicly listed and unlisted companies (Source: Capital IQ; based on global data available in Capital IQ’s database, August 2023).
Distribution of companies* between publicly listed and unlisted companies
By limiting their investment allocation to publicly listed companies, investors only cover 14% of the potential addressable market (number of companies). This likely results in worse risk-adjusted returns compared to portfolios that allocate to the private equity funds as well.
Historical returns clearly support this. Regardless of the source and details of the analysis, the outcome is always the same. PE funds have consistently outperformed the publicly listed market. The graph below shows a global return comparison between PE funds and MSCI World stock market index from the beginning of the 21st century to the present day. Over the last twenty plus years Private Equity funds have returned more than nine times their initial investment, while in the listed market, the investment has quadrupled over the same period.
Private Equity Funds consistently outperform Listed Equity
In addition, the world’s largest PE manager, Blackstone, highlights in its own analysis that US PE Buyout funds have outperformed listed stocks by approximately 7 percentage points annually since the early 2000s, which aligns with the findings shown above.
We should of course mention that past returns are not indicative of future performance. However, there are a number of reasons behind the excess returns and why we believe that the outperformance can continue. Firstly, by their nature private equity investments are illiquid, and thus should yield higher returns on average than liquid publicly listed stocks. This compensation for the loss of liquidity is referred to as the illiquidity premium. There have been several studies on the magnitude of the premium in research literature. However, there is no clear consensus regarding the size of this over time.
Secondly, the other part of the excess returns is attributable to the skills and ability of PE managers as well as leverage. In our view, this expertise can be divided into two main categories. The first is the ability to identify attractively priced companies among unlisted companies. PE funds still own a relatively small portion of all unlisted companies, so there is depth in the market to find undervalued targets, which can be at exit sold at higher multiples.
The second main category of expertise is the skill to improve the profitability and quality of acquired companies. We acknowledge that fund managers differ significantly in this regard, both in the methods they apply and the results they achieve. In general though, private equity managers have been proven to generate value through their work. We would also highlight that fund managers are able take a longer-term view and operate strategically over several years, without the need to submit to the mercy of quarterly economics unlike their publicly listed company counterparts.
Finally, we will not comment on the use of leverage to enhance returns in a greater detail here. Other than to say, that of course historically for most if not all the private equity funds, this has boosted performance. We will cover this in the future.
To summarize, there is an inherent illiquidity premium that investors should receive on their capital when investing in private equity funds. Furthermore, PE managers can identify and acquire undervalued targets and improve their profitability and positioning through their ownership over and above what the companies could achieve on a standalone basis. This leads us to conclude that for investors with the capital and means to participate in this part of the market the risk adjusted returns in their investment portfolios will be improved.
Important notice: The information presented here is solely for informational purposes. Fundco does not offer investment advice. Any content provided should not be interpreted as legal, tax, investment, financial, or any other form of advice. If you have uncertainties, it is recommended to seek guidance from an authorized financial advisor. Past performance does not guarantee future returns. Investing entails risk, and you should only invest funds you are willing to potentially lose entirely. Private equity investments carry high risks, and there may be limited protection in case of adverse events. Eligibility criteria apply.