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Private equity is becoming more and more accessible to everyday investors, but what is it, how is it different to investing on the stock market, what strategies can you employ and, most importantly, is it for you?
In episode three of the second season of our Unpacking Wealth Creation podcast, Kate Duggan, investment manager, and Sohan Singh, wealth manager (both at Investec Wealth & Investment) discuss the ins and outs, pointing to the importance of partnering with an expert private equity fund manager before plunging into what can be a complex asset class.
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Kate Duggan, investment manager, and Sohan Singh, wealth manager, discuss the ins and outs, pointing to the importance of partnering with an expert private equity fund manager before plunging into what can be a complex asset class.
What is private equity?
“It’s an investment into a privately-held business; in other words, a business that’s not listed on a public stock market," explains Duggan. "The funds invested in the private business will be used to increase the business’s value whether that’s through, for example, funding new technology, creating new products or making acquisitions. In general, the ultimate aim is to improve the business to a point where it can be sold for a greater value than it was worth at the time of the initial investment.”
What’s the difference between public and private equity?
“It comes down to liquidity. It’s generally the case that listed equities – i.e. those listed on a stock market – can be sold fairly quickly at their current value in a matter of days or even hours. So, you can access your cash quite fast if you need to. Private equity investments are usually longer term in nature – which means you may have to put your money away for five, seven or ten years. It’s only at the end of this term that you realise your investment because it takes a long time for a company to undergo the type of improvement changes.
“It’s also about pricing. Public stocks are priced every day; for example, you can access Bloomberg at any time of the day and get an up-to-date price for your investment whereas with private equity you have to be more patient. You’re probably only going to find out the value of the company every quarter or so. Based on these two aspects – the liquidity and pricing differences – private equity is considered more risky than public equity.”
What kind of due diligence goes into private equity investing?
Singh explains: “You really need to partner with an expert to invest in private equity. A listed company has to provide important information like its financials to the public, and it generally has hundreds of analysts researching it and holding it to account on various issues. There’s far less information available about private companies so you really need someone on the ground to go and look at the business, see what they’re doing on a day-to-day basis, what their strategy is and look at their financials. It involves a lot more work to uncover all this because the information isn’t necessarily publicly available so the due diligence process is generally more lengthy than for a listed entity. Experts will be better able to navigate such challenges than someone unskilled in the private equity space.”
What are some private equity investing strategies?
“There are three main types of strategies: venture capital, growth equity and buyouts. Venture capital generally happens after the business has approached friends, family and angel investors for early-stage funding. It involves going to the market to look for equity partners that can add genuine value to the business for a minority stake in the business," says Singh.
“Growth equity is sought once the business is more established but needs additional funding to growth further. Again, it’s important that the equity partner adds genuine value to the business even though it’s usually a minority stake that’s taken. Finally you get the buyout strategy, which is generally one step before public listing. The business being bought out tends to be quite a mature business and the buyer gets a majority stake in it so that they can be fully in control to drive the business’s growth.”
Where does this high-risk, high-potential-reward fit into a diversified portfolio?
“Private equity is an alternative asset class to the more traditional equities and fixed income.," explains Duggan. "Your allocation to it will depend on a lot of individual factors but as a very rough guide, alternatives could take up 5% - 20% of your portfolio depending on your liquidity needs and pricing."
What is a retail investor?
It’s a non-professional investor. In other words, someone who doesn’t invest for a career.
Is private equity an asset class for everyone?
“One of the main investors in the private equity market is pension funds. Historically, private equity was really reserved for institutional investors and ultra-high-net-worth individuals who could dedicate substantial amounts of money for long periods of time," says Duggan. "While it’s still the case that the asset class requires patience, it’s becoming more and more accessible to other types of investors, including retail investors.
“The asset class can offer really compelling returns and that’s what makes it attractive to all investors. But higher returns come with higher risks, not least of which is the illiquidity of the asset class, so it might not be suitable for everybody. It can also be incredibly complex. The different strategies Sohan mentioned can be difficult for your average person to understand and so it’s often more suitable for a retail investor to invest via a private equity fund that is managed by an expert fund manager, who can perform the necessary due diligence and operational checks on their behalf.”
“Not everyone should invest in private equity," says Singh. "A retiree, for example, probably shouldn’t be invested in private equity because they’ll need income that private equity probably can’t provide. I think private equity is generally something that more sophisticated investors should invest in. If you don’t fully understand the risks associated with private equity investment, including the liquidity constraints, it can be a very dangerous investment.”
How do I go about investing in a private equity fund?
“The first point in the journey is the decision to commit to one, and you’ll sign a commitment agreement with the fund manager," explains Singh. "Your capital won’t be called on day one – that’s quite different to a public equity investment where your money is invested on day one. The fund manager will go out and source the deals and there’s often a lengthy negotiation process around the price of the investments. Once these investments are identified, the capital is called upon – i.e. the fund manager draws down on your commitment and you will pay into the fund and that money is then allocated to the underlying investments.
“At this point in time, we often see what’s called the J-curve. In other words, your portfolio may generate negative returns in the beginning given the variety of costs associated with the start of investing: fees for lawyers, corporate financiers and fund managers. But as the performance of the underlying investments start coming through – as the fund manager creates efficiencies and improves the business – we hopefully see the valuation of the portfolio tick up and that makes a J-curve shape.
“As we go through the life of the fund, you should start receiving distributions from the fund as and when there are distributions from the underlying companies whether that’s in the form of dividends or as the manager sells out of specific positions. Once the fund is fully invested, the fund manager starts harvesting. In other words, they start exiting the various businesses and you hopefully realise a multiple of your initial investment.”