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The private equity alternative

By Claire Smith
 — 1 minute read

In an environment of low-interest rates and elevated valuations, investors are looking for alternative ways to generate much-needed returns and to adequately diversify their portfolios. Private equity can help advisers achieve this for their clients.

Claire Smith

This previously hard to access asset class doesn’t just offer investors an alternative source of returns, it also acts as an investment portfolio diversifier and offers a revenue stream of potential capital growth to help meet long-term goals.

The basics

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Private equity refers to company ownership where the company is privately owned and isn’t listed on a stock exchange. Private ownership offers a number of advantages for investors. It means a company’s management can focus on sustainably growing their business over the long-term, rather than focussing on quarterly earnings cycles and short-term drivers of valuations that their listed counterparts must generally adhere to. 

Their ownership structure means private companies are also less impacted by heightened public scrutiny and are not required to maintain the public continuous disclosure obligations of listed companies. This frees them up to take a long-term strategic view of performance. Consequently, private companies can focus on generating attractive, long-term returns, without the distraction of needing to publicly manage short-term market volatility.

A broader investment universe

Private equity investment opens up opportunities in a broader universe of companies than those listed on public stock exchanges. Investors have access to companies that are diverse in stage and size. In fact, many early-stage and growth-orientated companies can only be accessed through private equity, given the high costs associated with public listings.

Private equity investment fuels the growth of early-stage companies at start-up, into their growth phase, through to positioning for IPO, and can even intervene when a listed company becomes distressed and may return to private ownership during their phase of restructuring. This access to growth and transformation transactions across the company life cycle can boost private equity performance when compared to listed market companies, as public markets typically only cater for larger company sizes that can afford to deal with the complications of listing on a stock exchange.

Because of this, private equity investments can provide attractive returns and they generally have a lower correlation to major stock markets.

Another advantage of private equity investment, compared to listed equity investment, is the sheer size of the market. Over the past two decades, the number of listed companies in certain markets has fallen significantly. For example, across the stock exchanges of the US, Europe, Canada and Asia, the healthcare sector has an investment universe of less than 3,000 listed companies. In contrast, in the same markets, there are around 146,000 privately held healthcare companies.

One factor that keeps companies private for longer is the cost of meeting the growing oversight and disclosure requirements imposed upon them by securities regulators. These disclosure requirements have also increased significantly over time, resulting in more effort and resources to be made by listed companies to comply with the relevant regulations. Privately owned companies do not have this additional impost.

Accessibility

Once the almost exclusive domain of large professional investors such as superannuation funds, family offices and institutional investors, an increasing number of private equity opportunities are now available to retail investors and their advisers.

Traditionally, the barriers to entry for direct investors into private equity have been high. With large investment minimums, the requirement to meet periodic and irregular calls for capital and the inability to access the investment for up to 10 years, retail investors have historically been excluded from private equity investment. In addition, barriers such as a lack of transparency and understanding of the asset class, combined with complicated fee structures, have prevented retail investors from accessing this asset class.

Increasingly however, fund managers have developed private equity funds with accessible features. Innovations include:

  • Funding the investment in full at the outset rather than with periodic and irregular capital calls.
  • Holding a portion of cash within the fund to give investors a degree of access to their capital on a quarterly basis in case of a change in circumstances.
  • Reducing investment minimums.
  • Waiving performance fees.
  • Making the asset class available through wrap platforms.

Higher returns and increased portfolio diversification

Notably, private equity investments have the potential to outperform their listed equity counterparts – and many other asset classes – for a number of reasons.

The larger investment universe, combined with access to non-public research insights, gives private equity fund managers an advantage in portfolio construction.

Private equity companies typically trade at lower purchase multiples than listed companies. Quite simply, they are usually cheaper. Furthermore, buyouts of smaller companies have historically traded at more attractive purchase multiples than buyouts of larger companies.

Private equity investment in a company typically involves a board position and influence over company direction. For small, family-owned companies and start-ups with low management capability, significant value can be created by leveraging the expertise housed within private equity firms. Company inefficiencies are solved, growth is accelerated, and costs are reduced through customer expansion, M&A activity, managing cash, attracting talent, and improving IT systems.

Importantly, private markets have an illiquidity profile, which means they take time to dispose in an orderly fashion, and it is important for investors to be aware of this factor, particularly compared to listed company investments. However, the trade-off for holding assets that are less liquid is the expectation of a higher return as compensation.

The valuation frequency and valuation methodologies mean the volatility on these strategies is also typically far lower than that of listed equities. For instance, the volatility of Schroder Adveq portfolio of investments over the past 10 years is 6.9 per cent. This compares to the MSCI World that showed a volatility of 14.8 per cent over the same period.

Portfolio construction

Because of its broad investment universe, specialised valuation methodologies and its moderate correlation to listed markets, private equity can be used as an effective portfolio diversifier. When used in a portfolio with other assets, private equity can help smooth out volatility. Private equity is versatile and from a portfolio construction point of view can help diversify returns from the growth assets allocation or can form part of the alternatives allocation.

Claire Smith, alternatives director, private assets, Schroders

 

The private equity alternative
Claire Smith
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