What is private equity investment, its corporate structure, where they invest, and their growth and returns
The corporate structure and the type of private equity investment strategies
What sectors do private equity funds invest in?
Private equity is a long-term alternative investment in high-growth private companies at various stages of development and/or leveraged acquisition and restructuring of listed or unlisted companies, pursuing higher returns than those obtained in financial markets
Private equity is an alternative investment class and is capital, ownership or interest in an entity that is not publicly listed or traded.
Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.
Private equity firms bring capital and implement development and restructuring plans, playing an active role in the management of companies in close coordination with founders and/or managers.
Investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet.
Private equity investors seek to get returns that are better than those that can be achieved in the public equity markets.
Private equity investment comes mainly from institutional investors and qualified investors, who can provide substantial sums of funds over long periods.
In most cases, considerably long holding periods are often required for private equity investments in order to ensure the restructuring of companies in difficulty or the execution of the sale, either by listing to the stock exchange or a direct trade sale.
The minimum amount of capital required for qualified investors may vary by company and fund. Some funds have a minimum entry requirement of 250,000 dollars or euros, while others may require more than a few million.
The corporate structure and the type of private equity investment strategies
A private equity fund has Limited Partners, who typically own 99 percent of the fund’s shares and have limited liability, and General Partners, which owns 1 percent of the shares and have full liability. The latter are also responsible for the implementation and exploitation of the investment.
There are many private equity investment strategies. Two of the most common are leverage buy outs and venture capital investments.
Leveraged acquisitions (LBOs) are operations in which a company is purchased by a private equity firm and the purchase is financed through debt, which is collateralized by the operations and assets of the target company.
Venture Capital (VC) is a capital investment in a young company and in a less mature industry — for example, in internet companies in the early 1990s. Private equity firms often see potential in the industry and, more importantly, in the target company itself, noting that it is being limited, for example, by lack of revenue, cash flows and debt financing.
Private equity firms can take significant stakes in these companies in the hope that it will evolve into a powerhouse in its growing industry. In addition, by guiding the often-inexperienced management of the target along the way, private equity firms also add value to the company in a less quantifiable way.
In addition to investment strategies, private equity funds are also differentiated by the specialization of the business in terms of geography, sector, and size of companies:
Investment models and strategies are multiple, including start-up of companies, expansion or financial restructuring or business portfolio, with generalist or specialised policies, e.g. sectorial (technology, infrastructure, financial, industry, telecommunications) or business models.
Many leading global companies have been funded by private equity capital at an early stage of development or expansion, such as most technology companies (Microsoft, Apple, Facebook, Google, etc.), Nabisco, etc.
What sectors do private equity funds invest in?
The following graph shows the sector-specific specialization of private equity funds in terms of assets under management in 2020:
The main sector is real estate with almost one trillion euros. This is followed by energy and public goods with €600 billion, business services with €500 billion and software with €400 billion. Then comes a wide variety of sectors, from industry, health, tourism, consumer goods, etc.
The private equity industry has been growing consistently for several decades and in line with the returns
Private equity has grown in this millennium, from about $500 million in 2000 to $4.1 billion in 2019, up 12.2 percent from the previous year:
This growth in assets under management has been accompanied by an increase in the number of active management companies:
Almost 60% of investment strategies are targeted towards leveraged buy-out operations, and about 40% for venture capital, and the remaining strategies are not representative:
The private equity returns have been, for the average of their funds, higher than 3% and 5% per year than that of investment in the equity markets in the long term, offsetting the higher risk, term and liquidity premium associated with it
Alternative investments have different roles to play in an investment portfolio, from increased return, to risk diversification, to increased returns. In the case of private equity, the main motivation for investment is clearly the potential for improving return.
Given the generally high correlation between public and private capital markets, the transfer of capital to private individuals is more likely to increase returns than to improve diversification. Investors often aim to over-yield about 3% to 5% for their private equity investments.
The following table shows the premiums of annual private equity investment rates of returns versus those of the global MSCI World and U.S. S&P 500 stock indices for periods of 5, 10, 15 and 20 years:
Annual return premiums ranged from -0.4% to 7%, depending on indices and increasing with the term, reinforcing the idea of long-term investment in private equity.
A widely used way to make comparations between the returns of private equity investments with those of the public equity markets is to use indicators of these markets adjusted or equivalent to investments made, such as S&P PME (Public Market Equivalent):
Roughly speaking, this indicator corrects by the size, liquidity, and leverage of the listed shares.
We see that the annual internal rates of return on private equity investments of leveraged purchasing funds have exceeded the S&P 500 PME in the various investment periods between 1 and 30 years, with a difference of 5% per year for terms equal to or greater than 15 years. The differences for terms up to 10 years are less significant, mostly because this period coincides precisely with the bull market started in March 2009.
The following chart shows the evolution of average 10-year annual rates of return of private equity and S&P PME investments between 2000 and 2009 for the US and Europe:
10-year annual internal rates of return have always been higher in private equity than in public equity markets, both in the US and in Europe, reaching more than 10% in some periods.
Another aspect that should be noted is the lower volatility of private equity, especially in times of market stress, such as the Great Financial Crisis.
The following graph shows the absolute or accumulated performance of private equity investment versus the S&P 500 index between 1988 and 2018, using the logarithmic scale:
In this 30-year period the S&P 500 has gained 2 times or 100% and the Cambridge US Private Equity index of almost 10 times or 1,000%.
However, it is crucial to select the best private equity funds because there is a huge dispersion of these returns obtained by the different managers, as 50% of the funds do not match the equity market returns, and the 3rd quartile of the private equity funds has had even negative annual returns for periods of 5, 10, 15 and 20 years
However, given the multiplicity and diversity of private equity funds, it is very important to analyse the distribution of returns of these funds.
The following graph shows the annual returns for the best 25% funds, the average, the 50% of the funds and the 3rd quartile for periods of 5, 10, 15 and 20 years:
It is concluded that it is crucial to select the best funds.
In fact, there is a huge dispersion between the returns presented by the various funds and managers.
The best even had an exceptional performance, in the range of 16.1% to 19.3% per year, the median did not manage to beat the public equity market with values between 6.8% and 8.6%, and the 3rd quartile shows even negative annual returns, between -1.3% and 3.7%.
