By Giles Marriage
Beyond the quoted markets, where company share prices blink on trading screens on a second-by-second basis, there is a world of private companies invested within a £5.7trn industry of fund managers claiming a special set of skills for extracting value from them.
Investors able to take a long term view, who are seeking returns potentially higher and less correlated to the daily movements of equity markets, could find private equity an intriguing and useful investment.
The private equity ownership model allows a professional team of fund managers to take large stakes in private companies, to ensure they are run in the best interests of the underlying investors. This avoids the ‘agency’ problem of a dislocation between the owners of assets and how they are managed. For instance, for stock market-listed companies to run effectively, management stewards have a large degree of control over how the company is run, with reference to widely dispersed shareholders.
In state-controlled businesses, the dislocation to the ultimate owners, the taxpayer, is even wider. Other forms of company ownership, such as family companies, do not enable outside investors to access their returns. The private equity ownership model can be applied to a wide range of company types, sizes, sectors and geographies. The common factor is that all investee companies have unrealised potential. The aim of private equity investment is to unlock this potential.
Advantages of private equity
- Private equity ownership has a number of important advantages that allow it to create value and realise capital gain in a repeatable fashion.
- The universe of potential company investments for private equity is huge. It is a vast and unchartered land of opportunity. They can invest in unlisted companies that are at the beginning of their growth journey and in private hands; they can invest in the unloved divisions of larger corporations; or they can take private those listed companies that are unloved and underappreciated by the stock markets.
- Private equity firms are extremely selective and spend significant resource assessing the potential of companies, to understand the risks and how to mitigate them. Managers will often drill down from thousands of potentials to the one company that has all the right characteristics to achieve growth.
- Private equity firms invest in a company to make it more valuable, over a number of years, before selling it to a buyer who appreciates that lasting value has been created. Private equity firms are therefore patient investors, unconcerned with short term performance targets. But assets are held for sale, so they always have their eyes on the prize.
- The management team of companies owned by private equity are answerable to an engaged professional shareholder that has the power to act decisively to protect its shareholding.
- The combination of this clear accountability between company managers and shareholders combined with the need for a realisation means that incentive structures can directly link tangible value with reward. There are no rewards for failure. Such clear accountability has many benefits. For instance, it gives comfort to potential lenders, allowing investments to be leveraged.
Disadvantages of private equity
- Investing in private companies presents a number of challenges that are reflected in the traditional private equity investment experience.
- Restricted access. The traditional way of investing in private equity is through limited partnerships. These institution-only vehicles are mainly open to institutions and other larger sophisticated investors. They cannot be access by many types of investor.
- Barriers to entry. Limited partnerships require investors to commit very large minimum amounts (normally £10m or more).
- Private companies are illiquid by their nature. Private equity firms expect to commit to each investment for several years. For this reason, limited partnerships are commonly structured as ten year vehicles. Your money can be ‘locked up’ for a decade or more.
- Higher costs: encompassing such a vast and unregulated opportunity set as the private company universe requires resource, infrastructure and expertise. The due diligence required can translate into higher costs.
Overall, the size of the private equity market has grown steadily since the 1970s. For investors looking for attractive risk-adjusted returns relative to other asset classes, private equity has strong credentials. A broad range of institutions, including pension funds, sovereign wealth funds and endowments, as well as individuals, invest in private equity as it can offer a meaningful boost to the performance of their investment portfolios.
Giles Marriage is director of institutional sales at Thesis Asset Management
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