Private Equity Essentials

An Introduction to the Characteristics and Mechanics of Private Equity Investing

The vast majority of investors are familiar with one market: a liquid and public one where prices quickly reflect new data, almost everyone sees the same information, and news spreads in seconds across the global Internet. But there is a second, much larger market—the private company market—where information is highly inefficient. The lack of transparency in this vast market offers opportunity for investors who are able to access information about private companies and negotiate attractive terms to provide select companies with capital to help them pursue growth strategies and improve their operations.

This paper addresses the basic differences between private equity and public investments, such as stocks, bonds and mutual funds. It also explains how private equity fund managers create value, the mechanics of private equity, the fees charged in this asset class, and historical net returns. It describes the traditional institutional profile of PE investors, the various types of private equity strategies, how to think about a PE allocation within a high-net-worth portfolio, and concludes with some final observations for investors considering the asset class for the first time.

KEY CONCEPTS

• Private equity investments can add high return potential to a portfolio. On a net basis (after deducting all fees, including carried interest), private equity has outperformed major public indices by 300 basis points (3%) or more over 10, 15 and 20 year periods. ¹

• A variety of characteristics make private investments different than public investments, creating the potential for greater returns. Three of the most important factors are:

• the asymmetry of information in the private markets;

• the illiquid nature of private equity; and

• the large universe of private companies.

• Private equity plays a key role in the portfolios of many large sophisticated investors, including public and private pension plans, insurance companies, foundations, endowments and family offices.

• Private equity managers are different from public equity managers in that they actively seek to add value to their portfolio companies. They do this by selecting companies that have the potential for added value and then implementing creative and sometimes aggressive strategies and plans. Importantly, not all private equity managers are the same. Manager skill varies greatly and as a result, the return dispersion within private equity is much greater than in other asset classes.

• In evaluating private equity managers, investors should consider:

• how the manager seeks to add value;

• their track record and relative performance;

• the quality of the organization and team;

• the investment strategy and market opportunity;

• the investment process.

• Before allocating to private equity, investors should consider five basic elements: 1) their time horizon; 2) any short term liquidity needs; 3) where the investment fits in their portfolio; 4) their comfort with a relative lack of transparency; and 5) their understanding of fees.

• For those who determine private equity is right for them, the asset class can provide high return potential, diversification benefits and uncorrelated investment exposure.

ASSET CLASS CHARACTERISTICS

It is important to note at the outset that the private company universe is magnitudes larger than the public company market. According to the US Census, there are approximately 6 million companies with employees in the U.S., only about 5,700 of which are listed on the New York Stock Exchange and the NASDAQ combined.¹ By comparison, there are nearly 200,000 private companies in the U.S. with annual revenue between $10 million and $1 billion.²

In addition to the size of the market, a variety of characteristics make private investments different than public investments (see Figure 1 for a summary). Two of the most important factors for investors to understand about private equity are: 1) the asymmetry of information; and 2) the illiquid nature of the asset class.

Figure 1

PUBLIC MARKETS vs. PRIVATE MARKETS

Public

Frequent transactions
Access to capital
Information widely and quickly shared
Performance generally in line with the markets
Minority shareholders

Private

Infrequent transactions
More difficult for small companies to easily access capital
Asymmetric information
Performance premium to liquid markets
Hands-on, value-added control investors

Publicly listed companies are required by their regulators, namely the SEC, to issue annual reports and make other disclosures which contain extensive information about their finances, key operating metrics and strategies. Quarterly earnings announcements, press releases, and other public disclosures are heavily researched and reported on by Wall Street, and are available almost instantaneously worldwide due to the internet and a 24-hour news cycle.

Private markets are much more opaque because, unlike listed companies, privately held companies are not required by law to disclose any information to the public. As a result, it is rare for private companies to release material information about their finances or operations into the public domain. Instead, in the private marketplace, this type of information is confidential and often treated as a “trade secret”.

Second, private company investments are far more “illiquid” than public markets where investors of all types can transact instantly online. Private market investors generally transact very infrequently. Opportunities to invest in private companies occur when the existing owners decide to sell a minority or majority stake to monetize their holdings and/or raise capital to grow their businesses. Such events happen infrequently during the life cycle of a private company and, even when an opportunity to invest arises, prospective investors must be “invited” into a confidential sale process, which very often involves competing bidders. Buying and selling investors must ultimately agree on the value of shares based on confidential information and without the benefit of a public market that confirms their value. Because private company shares cannot be sold easily or quickly, they are considered “illiquid” assets.

Investors expect to be compensated for this illiquidity by receiving higher returns relative to other, more liquid asset classes. The longer-term investment horizon of private equity allows companies to pursue aggressive growth plans, restructurings, acquisition campaigns, and other strategies that are sometimes difficult to execute in a public market environment. Moreover, the vast majority of private companies are too small to issue shares in a public offering, and thus private equity provides them with flexible capital that is often otherwise unavailable. The long-term nature of private equity investments is part of what allows PE managers to create meaningful value and thereby provide investors with the illiquidity premium they require for locking up their capital.

The dynamic between the degree of liquidity and the expected return on investment is fairly intuitive. As Figure 2 shows, the more illiquid the asset, the higher the potential return. For example, the most liquid market in the world (U.S. Treasuries) offers zero illiquidity premium as all investors have the same information and can transact instantly, while the most illiquid market (venture capital) depends on information shared person to person and negotiated valuations and typically requires a long time for early stage companies to validate their business models and become profitable. A venture capital investment can take as long as a decade to achieve a successful exit.

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