Investing in private equity means understanding the asset class. The mechanics of a private equity fund and the role of key players defines risk and return of an investment.
In this first section, we’ll cover the basics of private equity:
To go back to first principles, equity is a stake of a company’s value. Public equity is a share in a company that is publicly traded on a stock exchange. Private equity is a stake in any company that is not publicly traded.
Public equity is considered as one of the three main asset classes, alongside bonds and cash. Private equity, however, is considered as an “alternative” asset class, alongside a range of asset types including private debt, real estate, infrastructure and natural resources.
This contrast may seem simplistic, but it defines a number of characteristics that are relatively unique to private equity, starting with how a fund is structured.
When a private equity firm creates a private equity fund, it forms a ‘Limited Partnership’.
The firm puts out a call for investors to contribute to a pool of capital that will be used to invest in private companies that fit within a predetermined investment strategy.
By contributing, investors become ‘Limited Partners’ of the fund. The private equity firm is the ‘General Partner’ of the fund and responsible for managing investments.
The goal of a private equity fund is almost always to eventually sell the stake in the company for a high return on equity. The strategy that funds follow to reach that goal depends on the fund and the sub-asset class it targets. These range from majority buyout and venture capital, to growth and structured minority funds, which we cover in detail in Explore strategies.
We will also cover the overview and structure of a private equity fund in more detail in How does private equity work?.
Leverage. Private equity investments are often financed using debt - ‘leveraging’ the transaction, hence the private equity industry is often referred to as the “leveraged buyout” industry. The practice allows for the fund to put down smaller amounts of cash, but magnify the gains if they sell at a profit. Of course, the reverse is also true: if the investment fails, there is significant downside risk.
Value-add operations. Since the goal of private equity investment is to eventually sell the stake in the company, there is a strong motivation to add value. Most modern-day private equity firms have clear value-creation methodologies and often dedicated value-creation teams within the firm. Value-creation initiatives may include reorganisation, cost reduction, technological improvements or introduction of ESG frameworks, all of which will be thoroughly planned out before any investment is made.
Higher risk / higher reward. Investing in private markets gives private equity firms access to companies that are untested, without the strict reporting that public companies offer. To manage this risk, firms operate large research and due diligence operations, closely examining the data rooms that potential companies make available to them. Firms often illustrate the rigour of their due diligence process by comparing the number of closed deals to the number of companies entering their pipeline. For example, a large manager might show that over a thousand companies are screened in a year but fewer than ten deals are closed.
Alternative funding access. When seeking out capital, companies can fund their growth through loans, often at high interest rates with a set repayment schedule. Otherwise - if they are ready for public listing - they face a level of scrutiny that applies pressure on regular earnings reports. Seeking capital through private equity funding offers an alternative route, with deals that are usually tailored to their unique needs.
Less scrutiny. Many innovative companies operate progressive growth strategies that may be too radical to pass the approval of wary public investors. For example, tech startups over the past two decades have been at the forefront of growth hacking techniques that are only taken on by more conservative companies once they are tried-and-tested. A private equity firm is more likely to accept the risks involved in a new strategy, especially in venture capital, where decisions to invest are often based on the vision and abilities of the founding team.
On top of that, public companies adhere to tight reporting regulations, while private companies don’t have the same requirements. By accessing capital through private equity - or taking the step to move from public to private - companies can pursue more innovative growth strategies.
Longer strategic horizon. When a General Partner invests in a company, the goal is to increase value over a period of years, rather than making gains quickly - as is the case for many public investors. The average holding period for private equity is three to five years, but it can stretch to ten years or more if the firm decides to reinvest: holding onto their stake by selling it to a later fund. This allows for companies to pursue prospects with a longer time horizon and execute on a value creation plan without too being blinded by short-term results.
Unique risk-return profile. Private equity funds offer particularly high returns that are less correlated to public markets. See Why invest in private equity for more on how private equity returns compare to other asset classes and how including private equity in a portfolio affects the risk-return profile.
Fees and carry. Private equity funds are actively managed meaning that the General Partner is usually heavily involved with both the strategic goals of the company and with its day to day operations. The result is that private equity fees tend to be higher than those for a managed portfolio of public equity. The most common structure in private equity is “2 and 20”, where the General Partner receives a 2% annual fee, as well as 20% ‘carry’ of profits above a predefined performance threshold. Many funds operate other structures, with lower fees to incentivise investment, or higher carry to ensure the General Partner is motivated to increase the value of the company - commonly referred to as “skin in the game”.
Low liquidity. Limited Partner stakes are subject to a ‘lock-up period’, during which the General Partner will use the committed capital to make the bold strategic changes to target companies within the portfolio. This means that investors cannot liquidate their position until the end of the fund’s term, usually ten years with optional extensions. This makes private equity investments far less liquid than public market assets, so investors receive a significant liquidity premium in return. If investors want - or need - to liquidate their positions before the end of the fund’s term, secondary markets may provide a solution (see below).
High minimums. Traditionally, an investor must put forward a relatively larger amount of capital to become a Limited Partner of a fund when compared to traditional public market vehicles. Depending on the fund, investment minimums are usually in the tens of millions, though a minority of funds require ‘only’ minimums in the hundreds of thousands. Until recently - with platforms like Moonfare opening the private equity market to individual investors at accessible minimums - access to private equity has been limited to institutional investors.
Delayed cash flows. Private equity investors commit capital at the opening of the fund and the General Partner calls this capital periodically as investments are made, but Limited Partners cannot expect to receive cash flows in return until late in the fund’s life. We cover the private equity return profile (also known as the “J-curve”) and the timeline of a fund in section How does private equity work?.
The unique characteristics of private equity can make it a beneficial addition to a well-managed portfolio. We will explore the advantages in Why invest in private equity?.
Private equity market - historic growth
Until the late 20th Century, public equity investment dwarfed private equity, but in the past few decades there has been a steady shift towards private markets, especially in developed countries.
Globally, the private equity market is growing far faster than public markets.
Breaking the market down by strategy and region gives a better picture of where this growth is coming from. When it comes to size, buyout funds make up around half of the market growth, with growth and venture capital making up around a quarter each.
When it comes to the number of funds, there are far more venture capital funds than any other strategy, followed by growth, then buyout. This may seem counterintuitive, but this pattern follows a progression of decreasing size: venture capital funds invest smaller amounts at an earlier stage of a company’s life than buyout, with growth in the middle. This means that even if there are more venture capital funds, buyout still dominates the market in sheer size.
At a regional level, North America (particularly the United States) makes up more than half of the market, followed by Asia, Europe and the rest of the world. This split is relatively representative of how long each region has been taking part in the industry, with Asian and European funds starting out a lot later than the United States.
We dig deeper into strategies within private equity in section Explore strategies.
Private equity market - a current snapshot
According to Preqin - a research house specialising in alternatives - the global private equity market surpassed $4.74 trillion at the start of 2021¹.
Taking private equity alongside other private market assets including private debt, real estate and infrastructure, the wider private market has surpassed $7.3 trillion.
Note that this is a static picture of the market in 2020, purely for illustrative purposes.
Private equity market growth - forecast growth
Deloitte - in their baseline case for growth - forecasts global private equity to reach US$5.8 trillion assets under management by 2025². In their prediction, Deloitte takes into account an important element: the proportion of investments that are not yet put to use (also known as “dry powder”).
The delayed cash flows and illiquid nature of private equity has historically reduced the level of control investors have over their portfolio. Increasingly, if investors need to rebalance their portfolio or seek urgent liquidity, they can look to the secondary market.
The private equity secondary market allows investors to liquidate their fund interests before the end of the fund’s term. Among other characteristics, trading on the secondary market alters the cash flow profile, provides urgent liquidity and lowers private equity blind pool risk for buyers. These aspects have led to the secondary market to grow rapidly as an alternative option for investors and equity fund managers alike.
We will cover the advantages of secondary investments in Why invest in private equity? and the mechanics of secondaries in How does private equity work?
The combination of the factors above put private equity as an asset class in the wheelhouse of large institutional investors. The main institutional players are pension funds, endowment funds and sovereign wealth/national reserve funds. All three are looking to maximise long term returns - for slightly different reasons - and all three are increasing private equity allocation.
Pension funds have a singular goal: to cover the pensions of employees after their retirement. The long time horizon of this goal - plus the steady stream of new employees - means that pension funds are looking ahead. So it makes sense that pension funds usually have some allocation to private equity. In the modern-day US, this is around 9% for public pension funds³.
An endowment fund is a pool of capital that is established by a foundation, typically held by a non-profit organisation like a university, charity or hospital. The organisation makes consistent withdrawals for a particular purpose and the fund is often designed to continue indefinitely.
One famous example is the Yale University endowment fund, previously run by the late, great David Swenson and long-considered as a benchmark for strong returns and asset allocation. When Swenson took over in 1985, the fund had about 80% allocation to US equities and bonds, with zero private equity. Today, the fund targets a 41% allocation to venture capital and leveraged buyouts, with US equities, bonds, and cash making up less than 10%⁴.
Sovereign wealth/national reserve funds
State-owned investment funds are an enormous pool of capital that may be held by a central bank - giving it economic importance - or simply the state savings. Since the end goal is the ongoing running of a country, the time horizon for investments is again very long.
The allocation of sovereign wealth funds (SWFs) to private equity is not only considerable, it is growing. Recent research aggregating the 35 largest SWFs found that allocation to private equity grew from 12.6% to more than 28.3% in the last two decades⁵.
Even at the high minimums typically required to invest in private equity, there are some individuals - or families - that can afford it. They make up a fraction of the total assets under management in private equity, but they have still found access through traditional means for decades.
Ultra-High-Net-Worth individuals / family offices
Ultra-High-Net-Worth individuals are those with investable assets over $30 million, of whom there are just under 300,000 around the world⁶. Much of this wealth is controlled by management firms called “family offices”, so here we will consider them together.
In a Goldman Sachs survey of family offices, there was an average asset allocation of 24% to private equity⁷. KKR research found similar results, with 27% of respondent’s portfolio in private equity⁸. Both surveys noted that the allocation to private equity is likely to increase.
Until recently, the high investment minimums required to tap into private equity had been an impenetrable barrier to entry for individual investors. This was the case even for High-Net-Worth Individuals (the estimated 13 million individuals globally worth over $1 million⁹) since minimums have historically been in the millions or tens of millions.
Now, with Moonfare, it is possible to access the private equity market with as little as €50,000. It works by aggregating individual demand into a feeder fund structure, which then invests directly into the underlying target funds. Plus, a secondary market is available as a solution to market liquidity issues (though liquidity is not guaranteed).
Find out more here or continue reading to learn about the benefits of investing in private equity.
Important Information: Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance. Your capital is at risk. Please see https://www.moonfare.com/disclaimers.
¹ Preqin Global Private Equity & Venture Capital Report 2021, February 2021. https://www.preqin.com/insights/global-reports/2021-preqin-global-private-equity-and-venture-capital-report
² The growing private equity market. Deloitte, November 2020. https://www2.deloitte.com/us/en/insights/industry/financial-services/private-equity-industry-forecast.html
³ American Investment Council (AIC) 2021 Pension Report https://www.investmentcouncil.org/wp-content/uploads/2021_pension_report.pdf
⁴ David F. Swensen, “Investment Philosophy,” 1985. See http://investments.yale.edu/about-the-yio. For the current asset allocation, see https://news.yale.edu/2020/09/24/investment-return-68-brings-yale-endowment-value-312-billion
⁵ State Street Global Advisors “How Do Sovereign Wealth Funds Invest? Less and Less Contrarian” January 2020 https://www.ssga.com/library-content/pdfs/official-institutions-/how-do-sovereign-wealth-funds-invest.pdf
⁷ https://www.goldmansachs.com/insights/pages/ widening-the-aperture-family-office-investments-insights-f/report.pdf
Not only higher returns and diversification. All the arguments for investing in private equity.
What happens at each point in a fund’s life, why and what that means for investors.