Public equities certainly grab the limelight. Information about publicly traded companies dominate newspapers’ business pages, thousands of websites provide stock picks, and the closing numbers for the major stock exchanges can be heard on numerous radio broadcast and TV news shows.
Despite all the attention, over the past two decades the universe of U.S. public companies has been shrinking. With fewer companies choosing to list on exchanges, more companies are electing to remain private for longer, creating attractive opportunities for private equity investors.
The Opportunity for Private Equity Investors
Private equity refers to ownership rights in companies whose shares are not listed on public exchanges. These investments provide capital to companies who cannot access capital through traditional public markets.
Investing in private equity provides exposure to a broad and unique set of businesses which are otherwise unavailable via the public markets. These investments typically offer a higher return potential along with lower correlations to public assets.
While investing in private equity has historically been reserved for institutional investors, individuals can also take advantage of the benefits of private equity. Depending on the investment structure, individuals must meet one of the following definitions to invest:
The Benefits of Private Equity in Your Portfolio
Return Benefits
As mentioned above, private equity offers investors the potential for enhanced returns relative to traditional equities. According to a 2021 McKinsey report, private equity has consistently outperformed public equities in the past two decades. Over the twenty-year period, private equity generated a 9.9% annualized return vs. a 6.4% annualized return for public equities.
For this reason, private equity has been a historically popular investment amongst US pension plans. Per the Chartered Alternative Investment Analyst Association, private equity performance achieved by large state pension systems over a 21 fiscal year period from 2000 to 2021 produced a significant 4.1% annualized excess return over public equity.
There are two primary reasons why private equity offers greater return potential for investors:
1. Liquidity Premium
Private equity generally compensates investors with higher expected returns than public equities because investors cannot access their investments for an extended period. There is a tradeoff of higher returns versus access to capital. This is due to the lock-up periods associated with funds, the inability to liquidate or readily sell the investments in more liquid public markets, and the premium earned on capital for extended equity investments.
2. Active Sources of Return
Private equity managers strive to create real value through active ownership and governance of firms. In general, there are three primary sources of “manager alpha” or outperformance:
- Governance engineering
- Financial engineering
- Operational engineering
Depending on their expertise, fund managers will strive to add value through one or more of the aforementioned active investment approaches, with the ultimate goal of boosting profits before selling a company at a higher multiple than the purchase price.
Diversification Benefits
In addition to the potential for higher returns, private equity also offers attractive diversification benefits relative to public equities. These benefits are primarily a function of private equity’s unique exposure to sources of return not found in traditional markets, such as investments in early-stage companies in high-growth product or industry sectors
According to the CFA institute, annual private equity IRRs demonstrated a negative correlation to annual S&P500 returns (-0.15), with just over half of the volatility (7.0% for private equity vs. 13.0% for the S&P500).
Private Equity Correlation to Public Equities (1994-2019)
Annualized Volatility (1994–2019)
Manager Selection Matters
Private equity managers come in all shapes and sizes, so it’s important to understand some the various investment approaches these managers may deploy.
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- Distressed investing refers to investments in companies that are struggling or coping with crucial financing needs.
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- Growth equity provides funding to companies looking to expand and progress beyond their startup phase.
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- Sector specialists are experts in industries such as technology, biotech, and energy, to name a few.
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- Secondary buyouts refer to the sale of a company owned by a private-equity firm to another such firm.
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- Carve-outs refer to the acquisition of corporate subsidiaries or units.
Because the approach, skill, and ability to create value can vary from one manager to the next, there has historically been a wide dispersion of performance among private equity managers—far broader than observed within actively managed equity funds.
Research from Cambridge Associates suggests a 20% difference between the performance of top-quartile and bottom-quartile private equity managers. Top-performing managers also tend to have a high persistence, which translates into a greater access to more favorable portfolio companies (the better the quality of the portfolio company the greater odds of generating a profit when its sold).
For these reasons, thorough due diligence and manager selection matters immensely investing in private equity.
Takeaways
As an investment strategy, private equity can offer investors attractive risk, return, and diversification benefits. For individual investors, the key to capturing these benefits is manager selection.
Working with a qualified financial advisor is one of the best ways for individual investors to address the issue of manager selection.