A Guide To Investing In Private Equity
Many thousands of years ago, humans started to build towns and cities. There they settled, abandoning their previously nomadic life.
In order to have food and shelter, they advanced from mere subsistence to providing services and making or trading goods for money.
Then, as now, anyone lacking the capital to establish or expand a manufactory, service, or trade might persuade family members or friends to contribute.
By the 15th century, larger, more complicated, investments necessitated a broader, more formal, solution.
So, in 1407, the Company of Merchant Adventurers of London was founded, a group of rich investors established under royal charter for the development of English cloth exports.
Private equity is now massive
Some 200 years later, the same approach was used to finance English trade in Asia, through a royal charter granted to the East India Company.
The British colonisation of Canada and America was similarly funded, as was much of the Industrial Revolution (1750-1850).
Nowadays, these schemes would fall under the most general description of private equity.
This is where specialised funds bring together investors for companies and projects that are not public, i.e., not listed on a stock market.
The funds are an important source of finance for businesses of every kind.
The total 2018 worldwide assets was worth $3.4 trillion, about the same as those for hedge funds and more than twice what they were in 2008.
The total excludes funds investing in debt, infrastructure, and property, which together add another $2 billion or so.
Modern private equity no longer depends on the contributions of the rich.
Such investors, while remaining a significant element, are dwarfed by institutions such as pension schemes, endowments, and insurers.
They are not only attracted by the high returns that private equity can generate.
It’s also the fact that those returns are often uncorrelated with those from public markets.
In other words, when private equity is doing well, listed companies often are not, or are performing less consistently.
A combination of the two asset classes in an investment portfolio can, therefore, smooth out the overall returns between good and bad years.
However, while non-correlation is surely helpful, the main attraction of private equity is its higher returns.
The chart above only tracks American experience, befitting the USA’s position as by far the world’s largest market for private equity.
Nonetheless, compared with the stock market, the outperformance and smoother progress of private equity are clear and well-replicated in other countries.
Those assets are managed in a wide variety of strategies, but three dominate: venture capital (also known as early-stage), growth capital, and buy-outs.
Private equity strategies
Buy-out has been the fastest-growing strategy over the past decade.
It’s also the biggest, comprising almost half of total assets, and the most complicated. It’s often called ‘leveraged buy-out’ (LBO) and focuses on established companies.
The strategy applies a hefty dollop of borrowing (‘leverage’) to buy out the shareholders of a company deemed to be bloated, inefficient, or otherwise in need of reorganisation.
Typically, the company has the high and consistent level of cash-flow needed to pay the interest on all that debt, which can be as much as 90% of its new capital.
A more typical level is 60-70%, but that’s still pretty high.
The new owners sell off the weaker parts, install new management, and generally revitalise the business. Then they usually sell it to another company at a substantial profit.
Because billions may be required to buy even a medium-sized company, the private- equity funds that use this strategy are the largest and, thereby, the most popular with pension funds and other big investors.
The strategy may entail job redundancies at the target company, while high debt levels make it vulnerable to setbacks.
It can also arouse controversy, attracting hostile media attention amid accusations of asset-stripping and corporate raiding.
A notorious example was the 1988 buy-out of RJR Nabisco, worth $24bn, a record at the time for an LBO and the subject of a bestselling book, Barbarians at the Gate.
Growth capital pretty much describes itself.
Even fairly mature companies can find it hard to raise capital for expansion or restructuring.
Cash-flow may be too low or inconsistent for borrowing the substantial sum required from risk-averse banks, or the owners may want to spread the risk of the planned investment.
A private-equity fund can help, supplying capital as either a loan or equity and taking a hoped-for profit when the loan is repaid or the company is listed on a stock market.
Early-stage, seed, or venture capital invests in start-up companies. It’s the highest-risk segment of private equity.
New companies are often established to commercialise new business ideas or new technology, so the failure rate is well above average.
However, if they survive and succeed, the rewards can be astronomic.
Most famously, venture capital is the lifeblood of Silicon Valley, the district near San Francisco that’s home to many of the companies that have driven the IT revolution and the internet, such Facebook, Google, and Apple.
Should ordinary savers dabble in private equity?
How can ordinary savers harvest the outsized returns of private equity? More to the point, given the risks, should they?
The answer is an enthusiastic ‘yes’, but it isn’t easy. Access to the funds is limited to those who can afford the high levels of minimum investment required, up to $25 million. It’s almost never less than $100,000.
Moreover, the most successful funds are usually sold privately to institutions and rich individuals with a history of investing in them.
Besides, these are not retail funds, which are open-ended and, usually, traded daily. Private-equity funds are closed-end.
So a would-be investor not only has to find one that’s looking for new money.
But, if fortunate to discover one, they then have to remain invested until the fund is wound up after seven or eight years.
In the UK, however, savers can invest with a venture capital trust.
This is a closed-end fund that, like an investment trust, is listed on the London Stock Exchange and can be traded on any business day.
These trusts also benefit from UK tax relief on both income and capital gains, but these advantages are subject to a minimum investment of £200,000 and a holding period of five years.
Private equity is rewarding but risky, therefore, and hard to access. If you want to invest, consult a professional adviser first.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
