Welcome to Finance and Fury. Looking at alternative to listed shares, with private equity.

Globally, private equity has for many years been a niche area of the investment universe, dominated by institutional investors and very wealthy individuals. However, trends in the US suggest the asset class is greatly increasing in prominence, reinforcing the case for including it in long-term-oriented portfolios across all types of investors.

So, is it worthwhile to invest in?

What is private equity – simply any share not listed for public purchase

  1. More private companies that public companies –
    1. Australian index – 2,761 listed but around 2.5m actively traded companies
    2. US index – around 6k companies listed, but 27m unlisted – or private companies
      1. Many of these private companies would just be holding companies, or corporate trustees, so not every one of these is a business that can be invested in
      2. But regardless, there are many more private companies than public companies
    3. Private equity is a large space –
      1. investors, venture capitalists, private equity funds or fund of funds can play a role.
    4. Private equity investing is not venture capital
      1. Venture capital characteristics – Invest in early-stage companies that are developing new and innovative – technologies, therapies, systems and processes.
        1. Provide capital and commercialisation skills to some of the country’s top scientific, technical and entrepreneurial brains.
        2. Often fund companies at the early development phase, which typically have higher risk-return profiles.
  • Generally, do not use leverage (i.e. debt) in transactions.
  1. Private equity characteristics – Buy into established businesses with growth potential that is already pretty well established – but looking for additional growth
    1. Have the greatest impact with companies that need: expansion capital
    2. capabilities for bolt-ons (acquiring similar businesses and merging with existing investments) and roll-ups (acquiring and consolidating a number of businesses in a fragmented market).

Opportunities and risks

  1. Both the benefits and the risks stem from the very nature of private equity – On the one extreme there is the highly speculative venture capital end – then the opposite extreme in equity investing with purchasing blue chip ASX funds, or index funds
    1. There is, of course, a great deal of middle ground in the life-cycle of a company between the seed stage and maturity
  2. This is where Private equity comes in – but can still covers a broad range of categories at various stages of the business ‘lifecycle’ – so the risk and rewards vary between each state of the business cycle
    1. Private equity offers potential for additional returns above what listed equity can provide, but there is no guarantee that the companies being backed are going to become the ‘next big thing’
      1. This is why most managers, to compensate for this risk, simply aim for higher-than-average returns.
    2. Advantages – comes in the form of Returns – People invest to obtain a return
      1. But Private equity can offers far less predictable returns — indeed, it might not be unusual to find money ‘trapped’ in an investment for some years without showing any returns
        1. How returns are calculated – no market value for the equity – not like a listed share anyway
          1. Works off a fair valuation – paper price – can help to make these assets immune to mass market sell offs due to fear – when say the fair value of a listed company may not change, but its share price may drop by 40%, as was experienced by some companies in the GFC
        2. Generally no income paid from private equity investments – returns normally come from capital growth – so to realise this, capital gains would be payable
  • Widely diversified portfolio this may not be a significant drag on overall returns, however, most retail investors do not have portfolios diversified to that extent – Super funds can have around 4 to 5% in private equity
  1. Different environments work – company not as much, superannuation can be more beneficial
  1. Correlation – or lack of correlation to other equity investments that are listed on the share market
    1. The listed equity sector – say buying shares on the ASX – can offer some predictability of returns over the long term due to historical data
    2. Private equity can be unpredictable – if the ASX is down, it is likely that shares in the US are down – but private equity investments may be up – the opposite may be true, when the share market is up, then private equity may be down
  • Due to the investments not being listed, if there is market fear or greed, then investors may not be over buying or selling private equity
  1. This helps to provide additional diversification
  2. Disadvantages
    1. Illiquidity – Investors are essentially required to determine a trade-off between returns and liquidity.
      1. If you do need money out quickly, these types of investments may not be for you – due to nature of private equity, generally funds may only have periods of redemption cycles
      2. But illiquidity can also be an investors friend – this is why the returns have a low correlation to the share markets – avoids mass selling out of fear – which can avoid the self fulfilling prophecy seen in markets like the ASX – where people have fear of markets collapsing, so they sell, pushing prices down, then others to avoid further losses sell, also pushing markets down
  • But this can have downsides – During the mid-2000s, a few private equity funds provided investors with liquidity by listing on the ASX – during the GFC, market confidence was shattered and mass panic selling occurred – due to the illiquidity of the underlying investments – the majority of these funds were eventually wound up and delisted
  1. This lack of transparency, lengthy investment horizons and the risks involved
    1. Most of the time, you don’t know what you are really buying – if you buy an index fund, you know the general make up – same with any listed structure – but with private equity, due to the lack of publicly available information on companies that are private, you may know what you are buying – so requires trust of the manager
    2. Listed private equity vehicles, as with many listed investment companies, often trade at a discount to the value of their assets. They have a smaller pool of investors to draw on compared with most exchange-traded equity funds, which are also composed of more transparent and easier-to-value listed assets –
  2. Costs – The underlying management costs for the funds are generally more expensive than the average active manager
    1. Net returns can be impacted with higher costs, or performance fees

Access – Historically, private equity has only been accessible through the wholesale market – not to everyday investors like you and I

  1. The illiquid nature of the asset class has been a barrier to retail investors, along with the large amount of upfront capital and the lengthy time horizon required – this is a space that just institutional investors have been attracted towards by the performance of private equity – along with the potential to deliver diversification benefits Over the last few years, you will find private equity in most industry funds allocations
    1. One high-profile illustration is the Future Fund, with A$149 billion under management – private equity to 14.8%, (A$22 billion), up from 11.8%
    2. But these are large institution funds, will billions of dollars to throw around – Traditionally this has been due to a lack of suitable investment options, including the absence of suitable vehicles with daily liquidity as well as difficulty in obtaining access to top performing private equity managers. It should also be noted that institutions are far better placed to wait out the lengthy lock-up periods (up to 10 years) and pay the substantial management fees that often apply.
  2. However, some managers are now offering listed funds. These place a liquid structure over the illiquid assets, enabling shares to be traded on the secondary market.
    1. But trying to match liquidity to illiquid assets can be a dangerous game and, given the nature of these investments, it may be difficult to establish a true value for a fund because there is often a lack of public information about many of the underlying investments.
  3. The options are managed funds or ETFs – listed and unlisted structures –
    1. These funds do the private equity investment for you – most of these that have seen are international for Australians – meaning they don’t invest in private equity domestically –
      1. Makes sense – we don’t have that many large well established private equity companies compared to the US, or other international markets like the EU
      2. Have to watch out for currency exposure though

Summary

  1. Private equity can provide impressive returns, but it is a high-risk asset class that may not be suitable for everyone.
  2. It is most suited to those with a high-risk tolerance and who can withstand volatility.
  3. also need to be prepared to make a long-term investment commitment without having a need for liquidity. Some funds may require investors to commit capital to a 10-year investment period. Even those invested in listed funds should be prepared to park their money there for the long term to ride out the various economic cycles and maximise gains.

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