Understanding private equity

Not all companies have a public life but, at some point, they all have a private one.

Private equity (PE) is one of several asset classes within private markets that allow you to tap into the growth and value of the large and diverse universe of private companies.

Watch Chuck Davis of Stone Point Capital discuss what private equity is

Why you should be excited about private equity

Diversification in public markets has been shrinking for decades. Public securities are now just the tip of the iceberg of the investable universe: only 14% of companies with revenue greater than $100M are trading publicly.¹

A tighter regulatory environment has also made it difficult and expensive for small to medium-sized private companies to list on public exchanges. In that context, over the past 20 years PE has been steadily growing as a source of capital for private companies (see chart below). Many of these companies are able to stay private longer, and even indefinitely, because of the funding and support PE provides.

On a very basic level, this means that if you are not investing in PE, you are missing out on exposure to a large swath of the US economy, while the diversification from even the broadest passive investing in the stock market has gradually reduced.

More importantly from an investment perspective, median returns from funds investing in this growing world of private companies have exceeded those from their actively-managed public counterparts over the last two decades (see chart below).

In combination, the growth and performance of private equity make a broad-strokes case for investing in the asset class. But it is important to take a deeper dive into what PE is and how it works.

What is private equity?

At its simplest, private equity is buying a stake in a non-public company, finding a way to increase the company’s value, and then profiting from an exit.

This exit is usually via an initial public offering (IPO), a sale to another private buyer, or some other “liquidity event” like a merger. Investors are paid with proceeds from those exits.

There are a wide variety of PE funds that pursue different strategies, typically targeting either different stages of a company’s life cycle and/or specializing in a particular sector, such as biotechnology or health care. But these are broadly grouped into two groups: buyout funds and growth equity funds.

Buyout funds

Buyout PE funds buy controlling stakes in more mature companies and pursue one or many value enhancement strategies, including:

• Basic operational improvements to boost growth and/or improve efficiency

• Optimizing the company’s use of assets and debt

• Merger and acquisitions activity, such as consolidating within an industry or vertical integration with complementary companies up and/or down the supply chain

Gregg Lemkau, Chairman of DFO Management, on private equity value creation strategies

Growth equity funds

Growth equity funds are a bridge between venture capital (VC) and buyout funds. Similar to VC funds, they do not seek full control of a company, making minority investments, but in more established companies with relatively proven business models that retain growth potential. They provide money and support to expand operations and accelerate growth. The expansion of funds in the growth equity space has been an important factor in companies remaining private for longer, with investment firepower that allows companies to pursue growth more strategically in the absence of daily public market pressure. 

How do I invest in private equity?

It is possible for investors to invest directly in companies or alongside funds, but that is not practical for the vast majority of people, so most invest in PE through a fund. But it is important to note that these are very different from mutual funds. 

First, PE investments are unavoidably long term - these are usually “closed-end” funds with ten-plus year lifespans - and during that period you cannot easily exit your investment - it is illiquid.² Unlike in mutual funds, there is no daily pricing in PE.

PE funds also take a “just in time” approach to collecting your money. Committed capital is the money you agree to invest in a fund throughout its life (read more here). Called capital is the money the fund manager collects from you as and when it makes investments (read more here). 

You get capital calls throughout the investment period. This means you do not have to provide all the money upfront, but you will need to have ready cash for when there is a capital call. These calls can come with little notice and you need to respond quickly.

The lifecycle of a PE fund

It takes time and patience to grow companies and earn returns. Like wine, a fund begins with its vintage year and then ages until it is harvested. This usually takes around ten years. PE funds move through distinct stages over their lifecycle: 

• Formation and capital-raising. The fund manager (or GP) defines the fund, including strategy and fund size. Legal documents are put together and contain the fund’s terms, governance, and fees. The GP then takes the fund to market, securing capital commitments from qualified investors, including high-net-worth individuals, endowments, and pension funds, among others.

• Investment period. This phase starts with sourcing, evaluating, and selecting high-potential companies that meet the fund’s strategic goals. The next step is extensive due diligence on those companies, including financial and operational analyses, background checks, and risk assessment. If all of the GP’s investment criteria are met, it looks to strike a deal. Depending on its size and targeted level of diversification, a fund typically builds a portfolio of anywhere from 10 to 25, or even more, portfolio companies.

• Active management period. The GP works with portfolio companies to devise and implement strategies to drive growth and add value (as per the discussion above). The GP closely monitors and reports back to investors/LPs on the portfolio companies’ progress.

• Exit or harvest period. When the GP is satisfied with the company’s financials, governance and market position, and - more importantly - deems that the market environment for a sale is appropriate, they create an exit. As discussed, common exits are IPOs, mergers, or private sales. Investors are paid from the proceeds of profitable exits, with the GP receiving an agreed-upon cut.

• Liquidation. When the fund’s last investment is complete, the LPs and the GP are paid and the fund is closed.

Returns from a PE fund

The structure of a PE fund’s life cycle means that the way cash is returned to investors is fundamentally different to that of public mutual funds.

Most simply, as mentioned above, there are no daily reported returns. Instead, investors will receive quarterly estimates of the value of the overall portfolio with that only turning into cash during the “harvest period” of the fund, which may not begin until 5 or more years into the fund lifecycle.

At the beginning of the investment phase, PE funds often produce negative returns, which forms the downward slope in what is called the “J-curve” (see chart below). This downward movement is because during the early stages of a fund, the fund is making investments. It may have to pay a premium to a company’s current value, resulting in an immediate (if short-term) loss. It may also face significant deal-related costs, such as legal fees and planned cash injections to implement its growth strategies. This decreases the fund’s overall value.

As the fund moves past its early stages, those returns tend to gradually turn positive as successful exits accrue.

This return structure reinforces the importance of remaining patient and committing to remain invested throughout the life of a fund. This is why we always stress that you should carefully consider what share of your wealth you can afford to be without access to before investing in private funds more broadly.

Fees in a PE fund

PE fund fees are structured differently from the flat fees you pay for a mutual fund. Designed to incentivize the GP to do their best, there are two types of fees, as well as some general expenses. We talk about this in more depth here, but in short…

Management fees

First, there is an annual management fee that covers most of the fund’s basic operating expenses. This typically includes salaries, office rent, legal and due diligence costs, and other administrative costs. This fee usually ranges from 1% to 2.5% of the capital you committed.

Performance fees

The fund manager also receives a share of the fund’s profits, commonly called carried interest or just “carry.” The standard carry is around 20%, but it may vary depending on the terms of the fund agreement. 

Carry is typically subject to a hurdle rate. This means that performance fees only start to accrue after investors get their capital back, as well as the pre-approved hurdle rate. At this point, the GP receives 100% of returns until their carry matches what they would have received if the hurdle rate did not exist.

Aligning interests

As this performance fee structure makes evident, there is strong alignment of interests in PE between investors and the fund managers. In addition, fund managers usually invest their own capital alongside their investors - typically about 1% of the fund total. This is sometimes referred to as the “hurt” fee because the GP will feel the pain of poor performance.

Put simply, if a fund is successful, the manager profits. If not, they take the losses alongside their investors. Of course, we should note that management fees provide a small amount of income for the manager throughout the fund life.

Risks of a PE fund…

As in any other investment, you can lose your money. There is a much wider range of outcomes in private markets than in public markets - and if you end up at the wrong end of that range, it means capital losses for investors and managers alike.

There are also market and economic risks for PE investments. An interest rate change, persistent inflation, or a recession can hurt a portfolio company’s performance and a fund’s opportunities to engineer a successful exit. Similarly, a change in the regulatory environment could also present a risk to the fund or to a portfolio company.

Finally, as we mentioned earlier, traditional PE funds are unavoidably long term and illiquid, which carries an opportunity cost for investors, while the lack of daily reporting is something investors would have to get comfortable with.

…and the rewards

Nevertheless, we would argue that with careful fund selection, appropriate levels of diversification, and the support of the right partners, private equity has a highly constructive role to play in a well-balanced portfolio.

Investing in PE offers you access to an expanding universe of private companies with tremendous growth potential, and exposure to interesting opportunities and economic trends that you may find hard to access via public markets. It also offers the opportunity to build long-term, diversified, and differentiated return streams, which may help dampen volatility and soften public market shocks for those willing and able to lock up capital for a sustained period.

Still curious? Click on the private equity tab on our Insights site.