Private Equity can be dangerously seductive: Here's how to invest in it responsibly

Investing in private equity can bag you very handsome returns - provided you know what you're getting into and can marshal the appropriate expertise to do it responsibly.   

As the old saying goes - there's no free lunch in finance. If you want bigger returns, you almost always need to take on more risk. 

When you invest in private equity, you're in it for the long-haul - typically 10 years. So  if liquidity is high on your priority list, it may not be for you. 

What's more, you need to do it via experts who know private markets. Indeed the top performers in the private markets can generate 15% to 30% returns above the median manager. 

That's where Credit Suisse come in.   

"We're fortunate that we partner with some global managers who have the expertise in that field, who are often specialists in certain areas," says Stephen Cabot, Executive Director Wealth Management at Credit Suisse. 

"So if they're a growth-focused organisation, they'll understand how to address the markets that they're investing in, the management that they can bring to that opportunity, and how they can monetize that."

In this wire, Cabot explains the intricacies inherent in private market investing, how Credit Suisse select their investment managers, and also the sectors and companies that stand out in the space.  

EDITED TRANSCRIPT

How are credit Suisse’s clients using private equity investments?

Stephen Cabot: Private equity is an important part of our clients' allocations. We talk to clients about starting with an allocation of 5% in the strategic asset allocation, but given the peculiar characteristics of private equity, that is, its illiquid nature, locking up investments for 10 years, along with its capital call structure, it can be something that you need to be fairly careful about managing. Because of these characteristics, some clients prefer not to have a large allocation. But on the other side, we have clients that are very comfortable with the illiquidity and adopt more of an endowment style approach where they'll allocate 20 or 30% to the private equity class. 

The allure of the returns from private equity is obviously an attraction, but it does need to be measured up with that illiquidity component to make sure that it makes sense.

What are the different ways investors can access private equity through Credit Suisse?

We have a number of ways clients can access private equity, and our core offering is a portfolio of private equity funds that we bring together. We like to treat that as a core offering that clients have. We'll get diversification by manager, by region, by strategies and by vintage. We like to encourage our clients to take up this core offering in an annual stepped process, as we bring them up to the market. 

That was the first way. There are opportunities where we focus on particular strategies or sub-sectors that individual managers will bring to the client base. We also have co-investment opportunities. These tend to arise through opportunities of partnering with big managers, and there can be some side opportunities to invest alongside them. However, they tend to encourage clients to do their own due diligence around, so again, this is not necessarily for everyone. 

Finally, we have what we call semi-liquid solutions, which is where clients can access a diversified solution of private equity opportunities. And they will handle smaller allocations, and so work quite well for our clients.

How do you evaluate private companies compared to public companies?

The key to identifying any opportunity is to determine what you should be paying for the investment opportunity. There's an enormously different skill set in applying that in the public market to a private market, and we're fortunate that we partner with some global managers who have the expertise in that field, who are often specialists in certain areas. So if they're a growth-focused organisation, they'll understand how to address the markets that they're investing in, the management that they can bring to that opportunity, and how they can monetize that. That is a different skill set from what we have in the public markets, where the same information is available for most companies, and everyone is assessing that. 

In the private market, it's a little bit more nuanced in what's available and how to assess it. So it requires special skills, and that's why we're pleased to partner with some big managers.

How do you select private equity fund managers?

The selection of managers in private equity is crucially important. If we look at the listed and public markets and the liquid markets of bonds and equities, the average manager generates a return, and with the top five percentiles, you'll get a return of 2% to 5% from equities and bonds in terms of outperformance. You definitely want to be invested in those managers where you can. 

In the private markets that extend enormously where the dispersion of returns is much greater. 

The top performers in the private markets can generate 15% to 30% returns above the median manager. 

Aligning with some of those top quartile managers is extremely useful and beneficial.

There is also a persistence of returns that comes from these managers, where they continue to be top performers. Being able to align yourselves with them is vital, and we're fortunate that the private equity programme at Credit Suisse has been going on for a number of years. There are some key colleagues we have that have generated networks and connections that have opened up these opportunities, and we're able to invest alongside some of these top-tier firms.

Which sectors tend to stand out for private equity?

If we look at the private equity markets today, technology and healthcare are two areas that stand out. 

The challenge in technology is that it is such a broad description of what's available out there because every industry is now using technology for efficiencies, for advancements. So it becomes really important to focus on those that have a specialty area, the sub-allocations that they're investing in. That's always going to be an opportunity in the current environment we have. 

Healthcare is another where there are enormous reasons for a lot of investment and opportunities, and they need capital to help develop these ideas. 

However, as mentioned, it is the full breadth of opportunities that are available out in the public markets. Where we're seeing companies aren't listing as quickly and staying private for longer. There are opportunities out there across the spectrum in terms of sectors, it's all about buying them at the right price.

Are private equity investments typically concentrated in earlier or later stages of a company’s lifecycle?

There are different styles of private equity, which open up different segments. We can start with venture capital, which is very early on. We can move to growth, which is a bit later and then buyouts probably later again, and we do have solutions in all of those areas. The returns can be a lot higher in the venture and can attract some more headlines. However, there also can be a greater downside in investing there. The risk is greater, and the chances of failure are higher. Once again, the diversification is key, making sure you're getting some exposure to each of those and just weighting those correctly in alignment with your risk profile is really the key thing to position.

Can you provide two examples of companies you’ve invested in?

Importantly, the opportunity set comes to Credit Suisse clients in a number of ways. The first I'm going to talk about is the co-investment opportunity. It was with McGraw Hill Education. So, this is a group that is responsible for the publications of education textbooks etc. They were in private equity hands but were looking at an M&A opportunity. With that, they wanted to really launch the business into a more digital delivery of education resources. They came to the market to look for some additional capital. Our clients were able to assess that and allocate some funds. It was extremely successful, it coincided with the pandemic, which saw a huge shift in the education sphere and a lot more moving to online education opportunities. Since then, they've been able to exit that opportunity, and it was held for, around 12 months. It was a two and a half to three times multiple. So, a very successful opportunity there. The other area where we have some very interesting opportunities that our clients have really taken interest in is climate innovation.

This is where we are partnering with a sphere of venture capital firms that are committed to making change to the climate. The view of Credit Suisse is that to make change, it's much better to allocate those funds in the private market, where we can get the creation of new technologies and new procedures, which have a real impact. In the public markets, we can choose not to invest in coal companies or oil companies, but someone else will invest in that opportunity for us, and money can still be made. If we can help allocate capital to these new companies, they're going to drive these new technologies, and that's a really interesting opportunity. We're relatively new in this space, but there's an enormous amount of tailwinds. The energy problem in Europe is obviously bringing that to the forefront. We've had the states sign some new legislation to promote it, and it's something that our clients have been asking for and are now exposed to and getting the opportunity to drive some change globally.

What tips do you have for private equity?

I think one of the key challenges for private equity investors is to understand the nature of the J Curve, which is the initial period where investments are made. Valuations are generally not being improved over that period, and there can be some costs involved in running the funds, and getting the opportunities where we want them to be. This is where you can suffer this drawdown. So in the first year or two, that can be a hard challenge to come into groups with. If we can see over the valley and look forward, great opportunities open up, but those initial couple of years can be very challenging. Without the opportunity to sell in a public market, certainly at a sort of market price, you don't want to be in the situation where you're forced to sell. So a long-term approach and comfort and understanding of the J Curve are vital.

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