The Mystic Science Of Private Equity

While the world of investments is full of jargons, there is one such jargon that has been gaining attention for some time in all segments of investors – …

Private Equity

While the world of investments is full of jargons, there is one such jargon that has been gaining attention for some time in all segments of investors – Private Equity. The name not only draws admiration but also a sense of mystery about this investment avenue in the eyes of investors. One is always curious about the very basic who – what – why – how of Private Equity. Capital raising for companies has been a continuously evolving area and has undergone tremendous evolution. The way it has evolved from the traditional debt-based capital raising to new-age methods of Private Equity etc. is no less in comparison to the evolution of the stone age to the plastic age.

What is private equity?

The term “private equity” – comes from equity investments made in companies in private mode rather than through public offering.  Private Equity (PE) is a mode of financing where a group of investors get together for a motive – which generally is either investing in private business, buying out a public company – which subsequently results in the delisting of the public company from the stock exchange, distressed debt investing, and the private financing of public infrastructure projects. Thus, many different investing activities requiring specific expertise are often collected under the umbrella of private equity.

These are opportunistic funds where the motive is to make strategic investments and sell them off once they make sizable returns. Generally, such funds invest in companies with scope for improvements or expansions in the existing business models such as – new technological innovations, expansions, stressed companies. Private Equity investments can be made directly in private (non-public traded) companies or the collective form as PE funds i.e. pooled investment vehicles through which a group of investors may invest in a target company. PE as an asset class has received much-deserved attention. 

How private equity opportunities arise?

Where do market opportunities come from? This is the first question that we need to answer. There can be many reasons behind the rise of such opportunities, where the capital requirement for future growth and expansion comes at the top. Private businesses are generally closely held – meaning the ownership of such businesses sit in the hands of family and friends. Family-owned businesses often have limited capital and after a certain level, they need external capital to expand their business. At the same time, they are not keen on dilution of their stake so private equity is one ideal solution for them. 

Lack of expertise in running the company affairs is another. A classic example will be an idea-based start-up company where the founder came up with the idea and started the operations, however beyond a certain point, lacks the skill of running an entire company. This is where the founder will not mind giving entry to private equity, who bring along expertise in running companies of variable sizes.

Another reason is the reduction of the concentration of wealth for privately held business owners. A major portion of their net worth is represented by the family business and by selling some stake, they can generate liquidity which is further utilized in achieving diversification of their portfolio.

How does private equity work?

Investment phase

Providers of private equity capital categorize business in two main categories – Initial Stage and Expansion Stage. Initial stage companies are commonly known as “start-ups” and the future is quite unknown. These companies are currently looking to establish a foothold in the market. This is further divided into different levels, depending upon where the company operations stand. It could be the seed stage where the idea is taking shape, could be a start-up, or first-stage financing where the company has established itself and is slowly progressing towards further expansion. 

The expansion stage, as the name says, are those companies that have successfully survived the challenges of the initial stage and are prepared to go big in the market. This stage of funding is primarily focused on expansion in volume sales etc.

Exit

This is often the problematic area. For exiting a private equity investment, one needs to evaluate the current business and accordingly put a price to it. As these are not publicly traded companies, often pricing is the bottleneck for the exit stage due to lack of convergence on pricing by seller and the buyer. However, if this has been agreed then routes for private equity investors include – merger/acquisition with/by another company or by going public via IPO route (IPO – initial public offering) where these investors offload their stake to the common public. It is worth highlighting at this point – exit marks the end of successful private equity investment, however, it happens quite often that investors don’t even reach this stage and have to offload their investment at a discount, thereby taking losses on their investment.

How do private equity investments compare with investments in public companies?

Private equity investors have the liberty to negotiate the price and structure of investment they intend to make in the company whereas, in the case of public investments, price and everything is just in the public domain i.e., trading on the exchange leaving no scope or requirement of negotiation.

Private equity investors can demand access to all information which may include the company’s internal and confidential data that has not been disclosed to exchanges and regulators whereas for public investments such requirement is limited to data filed with the exchanges and regulators by the company.

Once the deal is done, private equity investors generally seek an active role in the operations of the company. This could be through the nomination of a board member or some other position in the company’s management ensuring active participation in the operations of the company. In public companies, on the contrary, participation post-investment is quite dormant, and investors have no active participation in the day-to-day operations of the company.

Lastly, the private equity investors face issues with the liquidity of investment which is mainly due to lack of buyers & sellers and the way investments are valued as there is no standard procedure for valuing these investments. On the other hand, public companies are listed on stock exchanges where there is no dearth of liquidity and no ambiguity in the valuation of investments. 

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Dynamics of private equity market

Private equity is treated these days as an essential constituent of portfolio management. It has received much-deserved attention from a variety of investors – pension plans, endowments, foundations, as well as from family offices and other advisers to the private wealth market.

From a portfolio diversification viewpoint, private equity has proven to be an essential component of one’s portfolio due to its unique risk-return profile. While risks involved are certainly higher, one may consider them due to the higher returns delivered by this asset class consistently. Moreover, it also has a different investment profile as an alternative investment to traditional stocks, bonds, and mutual funds.

On one hand, the economy is struggling with post covid recovery, at the same time private equity deals are touching new highs. As per PWC Moneytree, Q1’21 investments through such transactions has surged to a new quarterly record, with close to $64 billion being raised in this manner. This itself is indicative of the potential this alternative investment may have in near future. 

How to Invest in Private Equity?

Private equity has always been kept away from retail investors primarily due to the inherent risks and complexity level of this asset class. The direct mode of investment is open only to a section of investors where the requirements are quite stringent. As per SEC directive, accredited investors are one such subset of investors permitted for investment and requirements are either net worth of $1million or sole income of $200,000 (along with spouse $300,000) over the last two years and similar expectation in the current year as well. Along with eligibility criteria, initial investment size is also quite high ranging in a few hundred thousand dollars. 

Subsequently, an indirect route of investing has also come up which allowed even retail investors to participate in private equity. This was in the form of private equity – exchange-traded funds, PE-ETF funds. In the United States, PE-ETFs are just like usual stocks and are traded on stock exchanges which helps to improve the liquidity and removes pricing ambiguity to a certain extent. (ETFs – are funds pooled together for investing with a motive which could be a group of companies or an index. As the name suggests, they are traded on an exchange and act just like usual stocks from a trading perspective).

Below data from etf.com suggests there are 7 PE-ETFs currently trading on the US exchange catering to a total of close to $900 million of capital invested in these.

PE-ETFs Trading

(source: etf.com)

It could also be that the returns offered by these funds have a high degree of dispersion with the highest 3-month trailing return as 14.4% and lowest being -29.30%. Not just this these funds also have a tricky fee structure which is quite difficult to interpret from a retail investor perspective.

Key considerations to keep in mind – due diligence

Management Quality 

One of the key factors which help in deciding the fate of the private equity investment. As these are all non-traditional ideas being brought to life, quality of management and its experience in dealing with similar situations in the past is one of the most important factors (if not – the most). This not only involves the management responsible for managing the investment but also the key personnel of the target company in which investment is being made. And as mentioned earlier, private equity investors have access to all kinds of information internal or external (filed with regulator and exchange) so due diligence about the management needs a detailed analysis. 

Commitment of the Managers

Skin in the game – says it all. How many different investments are being managed, does the investment management team own a percentage of the company, how is the compensation of the management team structured and how much net worth of the management team is invested. These are those questions that psychologically give satisfaction to the investor about the investment. 

A higher number of schemes being managed may lead to a lack of focus whereas investment in the target company or the private equity investment makes one believe that the management itself will be keen to excel in this venture. Conversely, if the managers have little cash of their own invested in the company, it will cast commitment doubts on the intent of the managers.

Linking the compensation with the performance has been an age-old solution to aligning investor’s interests with those of the management team.

Employment Contracts and Intellectual property

Checking the nature of employment contracts with the employees is important as well. Whenever there is a shake-up at the top level, often it leads to retention offers along with some redundancies. A sneak peek into employee contracts will help in analyzing the impact both operationally (from retention of key-employee perspective) and financially (caused due to redundancies, if made). 

While it depends on the underlying business, but, quite often, intellectual property plays a key role in the projection of future cash flows. This is driven by any patents about technology, designs etc. held by the company and how vital they are from a value-generation viewpoint for the company.

Quality of existing investors

This one is a cheat sheet. If you want to avoid all the due diligence, then just look for investments where investors of proven pedigree are already invested. However, the presumption is that existing investors must have been through the same exercise which you as an investor are trying to go through again.

Evaluation of probability of success 

The investment here is being made with an idea in mind, it could be a distressed asset, restructuring plan or any other strategic motive. As an investor, one needs to evaluate the probability of success in the strategy concerning the product and the target segment. Careful study and understanding of the business plan and its execution holds key from the strategic motive angle.

Risks involved in private equity investing

As with all investments, there are certain risks that an investor should be aware of before investing in private equity which may lead to capital loss or erosion. Risks inherent in the direct mode of private equity investing are:

Equity Market Risk

Just like the usual stock market, the stocks held in the portfolio of the underlying fund may experience unexpected and sudden drops in value and this may continue over some time. In US stock markets, it was observed during the 2000-03 (dot come bubble) and 07-09 (financial crisis). This may occur due to macro or microeconomic changes in the financial environment and may affect a specific segment of the economy more than the others.

Illiquidity Risk

Illiquidity risk refers to the lack of buyers and sellers of a particular investment. Alternative asset class (to which private equity belongs to along commodity, real estate etc.) suffer from this risk the most. Market participants in this asset class are far less compared to traditional investments (bonds, stocks etc.) due to various reasons like – high capital investments, lack of clarity on valuations, regulatory issues and many more. All this leads to a loss of opportunity of not being able to sell the investment when it is profitable due to scarcity of buyers and the seller subsequently must downvalue the investment to match the buyers’ expectations. 

Market Events Risk

This is relevant in today’s time and is quite infrequent by its nature. Market events refer to the events led by macros that could be economic, political, and health-related. This can directly be related to the current situation caused by covid-19 and its impact felt particularly on public health and the economic situation globally. Lockdowns across countries have made economies vulnerable on numerous different fronts and thus can be a volatility-inducing factor in asset prices. Other similar events are budget, elections, and war-related information which have the potential to cause disruptions leading to volatility.

While the above risks are related to the direct mode of private equity investors, in addition to these, there are some other risks as well inherent to ETFs applicable to retail investors who participate through PE-ETFs:

Non-Diversification Risk

As the name suggests, these ETFs are “non-diversified” and may have the concentration of investment in a single name issuer or an issuer of the same segment. This results in enhanced sensitivity in the fund’s value subject to change in the value of issuer/s. This means that ETFs value will go up/down more drastically compared to a diversified fund when a change in the value of the underlying issuer happens.

Portfolio Turnover Risk

Portfolio turnover refers to the frequency of buying and selling in a given time frame. These PE-ETFs are active funds implying that buying-selling will be part of the underlying strategy and this often leads to higher turnover. Higher turnover leads to higher transaction costs which form part of fund fees and thus reduce actual returns to that extent.

Conclusion

Going by the golden rule of investment philosophy, buy low sell high continues to be the underlying principle of private equity investment as well. This investment however offers a unique risk-return profile and should form a part of 0%-5% of medium to high-net-worth individuals, keeping in mind their risk appetite. Also, it is imperative to consult your financial advisor before making any changes to your portfolio.

About The Author

Ankit Mohan is an ex-investment banker and a freelance finance writer. He is an alumnus of London School of Economics and passionate about finance discipline and its application in daily life. When Ankit is not thinking about finance, he is busy dealing with his two toddler daughters who keep him busy for sure.

 

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