Follow the smart money into private equity

Private equity plays a vital role in the financing and in the support of new and growth technologies.

Some of the biggest companies in the world — Apple, Google, Meta — all blossomed from start-ups to listed mega-caps with the assistance of private equity.

Private equity deals have only been accessible for the very largest institutions or wealthy individuals.

That is changing.

What is private equity?

Put simply, private equity is the ownership or interest in a corporate entity that is not publicly listed.

There are different types of private equity investment. It can involve taking a stake in a growing business, making direct loans to business, or it can be taking control of a company either through outright purchase or through obtaining a controlling equity interest (buyout).

Private equity provides capital to nurture expansion, new products or restructuring with the goal of unlocking greater value for investors.

Traditionally, direct investments in private companies and in private equity funds require:

• Large capital outlays
• Long lockup periods
• Investors taking a concentrated, illiquid exposure to a small number of private companies – which are often leveraged.

As you can imagine, private equity management fees can be significant and traditionally only the largest institutions have had the resources to build a diversified portfolio of private equity funds.

Diversification across vintage

Vintage exposure refers to the year in which a fund began making investments. The vintage is important because in unlisted funds, private equity investors generally experience what is known as the ‘J-Curve’ effect.

You can see in the chart above, investors in private equity typically endure drawdowns during the early years of the investment, these are represented by the teal bars above.

During this time, the private equity investor endures negative returns as the business establishes (or re-establishes) itself. As the business matures, it requires less capital.

Cash flows increase and eventually it starts to return income to investors. Over this time, the value of the private equity investment also increases.

Accessing private equity via an ETF that tracks listed private equity companies can mitigate this effect because the underlying portfolio can comprise a range of existing investments that are at differencing stages of maturity.

The LPX50 Index is widely considered the market benchmark and includes the 50 largest and most liquid private equity companies with exposure to venture, growth and buy-out opportunities.

Why private equity now?

For many years, only the biggest institutions have been able to allocate to private equity. That is now changing and it is becoming a bigger part of portfolios, particularly SMSFs with long-term investment horizons.

2021 has been a record year so far for private equity and this has been reflected in performance. Private equity activity now represents 30 percent of the M&A market, surpassing the prior peak of 25 percent in 2006, according to a report released last week by Ernst and Young.

Throughout the first three quarters of 2021, private equity firms were involved in US$868 billion worth of acquisition deals globally, “putting the industry well within striking distance for its first trillion-dollar year on record,” EY said.

The report cites three factors for the growth of private equity activity:

1. Cyclical: driven by a strong earnings season and persistent low interest rates
2. Idiosyncratic: highlighted as businesses navigate and return to pre-pandemic levels of activity
3. Secular: regulators, particularly the Securities and Exchange Commission, has been encouraging retail investors to enter the private markets and listed private equity is facilitating this.

Similarly, Deloitte recently released a report that found that coming out of crisis such as the COVID-19 pandemic, private equity becomes even more important, providing companies with capital and industry expertise to help them weather the crisis better.

Deloitte found the demand for private equity funds is increasing as high returns and perceived low volatility continue to drive inflows from both existing and new institutional investors.

In 2020, 66% of institutional investors invested in private equity, up from 57% in 2016 according to the report.

In addition, as the public market equity valuations rise, private equity funds may become relatively more attractive to investors on a valuation basis. The S&P 500’s forward price-to-earnings ratio (27.5 times analysts’ next year’s earnings estimates) has reached a decade-high level.

We believe demand, toppy valuations elsewhere and the uncertain environment bodes well for private equity.

Long-term performance

The private equity asset class shows a long-term outperformance compared to the traditional equity market.

A private equity ETF will shortly list on the ASX and will open up access to this asset class to retail investors.

Australians, for the first time, will be able to Invest in a transparent portfolio of listed and liquid direct and indirect private equity as well as private equity managers.