Private Equity: Opening Pandora’s Box of Private Equity Strategies
Insight Highlights
- Comparing performance of private equity strategies vs S&P 500
- Difference between private equity and public equity
- Explaining commitments and capital calls in private equity
- Diving into buyout, venture, and growth equity strategies
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For Financial Professionals Only
Private equity is a buzzword that has gained traction as some investors seek to diversify from traditional stocks and bonds and participate in the investment of private companies.
According to PitchBook, when observing the 15-year horizon IRRs, the private equity sub-strategies of growth equity and buyout each returned close to 13% vs. S&P 500’s 9.7% annual return for the same period. The performance of other PE strategies and venture capital were more mixed during that same time.
Private market strategies' performance comparisons by year
As private equity receives more attention in today’s world, it would be helpful to have a guide to private equity and a breakdown of the various private equity strategies.
What is Private Equity?
In a simple definition, private equity refers to an ownership stake in a private company, akin to how public equity (i.e. stocks) represents ownership of a public company. One of the biggest differences between public and private equity is how investors can buy into it.
With stocks, an investor can open a brokerage account and purchase a share of a public company on the open market for a stated price. For the US market, investors can usually buy and sell shares of public companies and execute the transaction in mere seconds. Technology has greatly improved the trading process and made it simpler for investors to participate in the public market. Additionally, more and more retail brokerages are introducing the concept of purchasing fractional shares.
While technology has significantly improved the process of trading public equity, little progress has been made for private equity, largely due to the nature of the asset class. Private equity doesn’t have a transparent marketplace when compared to public equity markets. Furthermore, shares of private companies aren’t freely tradeable; and when they do trade, transaction sizes are very large. Since investors don’t have the same access to transact as in public companies, investors typically partner with an asset manager to invest in private equity. These asset managers have teams focused on sourcing and performing diligence on potential investments with the hope of generating outsized returns.
Managers will raise capital for a fund with specific investment parameters and have investors provide the funds to make such investments. The fund will invest in a series of companies based on the targeted private equity strategy outlined in legal documents. The legal documents will dictate, among other items:
- Investment Mandate: what the fund is investing in
- Timeline: when will the investments be made and exited
Commitments & Calling
Once clients are subscribed to a fund, clients have their commitment "called" over a certain investment period to be invested per the private equity strategy. How this works mechanically is that clients commit a certain amount to a fund, which is periodically drawn by the manager and locked-up for a stated period. A client will be officially invested into the fund once the fund issues a capital call notice. The notice will require the client to send a certain amount of their commitment to the fund manager and represents the client investing their capital into a private company. The capital call notices continue until the investment period is over. The investment period is typically the first 3-5 years of the fund the investor has committed to.
After the investment period is finished, the fund will start exiting their private company holdings and distribute the proceeds back to clients. The distributions will continue until all the investments have been exited, and the fund has been fully wound down.
The lack of liquidity makes private equity inherently more complicated and riskier than public equity markets, which for the protection of consumers, led to regulations requiring investors to meet net worth requirements before investing, typically $5 million for individuals and $25 million for entities.
Despite its complexity and inherent risks, like lack of liquidity, private equity can bring meaningful advantages for client portfolios, such as diversification from the volatility of public markets. Once clients understand the risks and potential rewards associated with investing in the space, adding private equity to an asset allocation can help clients achieve certain portfolio goals.
Different Strokes for Different Folks — Discussing Private Equity Strategies
Just as stocks pervade virtually every sector, investors can find a similar ubiquitous market for private equity. The asset class can be broken down into the different private equity strategies, below:
- Buyout
- Venture Capital
- Growth Equity
- Infrastructure
- Real Assets (i.e. Real Estate and Natural Resources)
The strategies buyout, venture capital, and growth equity, point to investments made at various parts of a company’s lifecycle and the subsequent the risk/reward characteristics.
Buyout as a Private Equity Strategy for Middle Cap Companies
When discussing private equity, most people think of leveraged buyouts. This popular private equity strategy focuses on purchasing stakes of established and profitable companies, typically with existing operations, a steady consumer base, and functioning products. These companies are typically described as in the middle market, usually defined as having revenues between $10 million and $1 billion and closely comparable to small or mid-cap stocks.
Key to Operational Efficiency
The manager will target companies that could increase in value from the fund manager's operational expertise. Usually, the fund manager will take an active role in leading the company through the next stage of development via a controlling stake and typically stay invested for 2-5 years. Once the private equity manager feels the company is ready, the manager will likely seek an exit via a strategic sale or initial public offering, IPO. Target returns for buyout funds typically range from high mid-teens to twenties.
- Target Company: established companies with existing consumer base and proven product, small/mid-cap companies
- Need: control stake from manager to optimize operations
- Exit: Strategic Sale or IPO
- Risk of Capital Loss: Low
- Holding Period: 2-5 years
Venture Capital as a Private Equity Strategy for Startups
Venture capital ("VC") is a private equity strategy that looks to invest in start-up companies, which need funding to develop their idea and ultimately take to market. Unlike the established companies targeted in buyout funds, start-up companies don’t have a track record of operations, stable consumer base, or even a product. At times, a start-up company just has an idea believed to disrupt the current status quo. VC funds grew in popularity during the dot-com boom with investors looking for the next Apple or Microsoft and were later satirized with shows like HBO’s Silicon Valley, highlighting the amount of money chasing ideas to find the next big project.
High Risk, High Reward
While buyout funds look to generate growth from optimizing operations, venture capital funds seek growth through R&D advancement to further the start-up's novel concept. Venture capital managers will structure their investment as a minority stake since the founder will need control for the development of their concept.
These startups are typically several years away from an exit opportunity, typically held between 5-10 years by the VC manager since the company is focused on product development. The exit strategy will typically focus on a strategic sale or an initial public offering, IPO.
Given investors are taking on more risk by investing in less-established companies, investors expect to be compensated with higher returns. However, the high-risk, high-reward paradigm doesn't always come to fruition, which is where manager selection matters. Usually, venture capital funds will manage expectations to have a couple of breakout stars in their portfolio to recover potential losses from other investments. Top venture capital managers seek to minimize their losses in their portfolio by often leveraging their network to find start-ups where they are comfortable with the development risk. Target returns can range from mid-teens to high-twenties but are highly dependent on the manager and prior track record of investing.
- Target Company: start-up companies with an innovative product concept
- Need: minority stake to provide capital for R&D
- Exit: Strategic Sale or IPO
- Risk of Capital Loss: High
- Holding Period: 5-10 years
Growth Equity as a Private Equity Strategy for Everything in Between
Much like a Goldilocks scenario, some investors may find buyout as too established and venture capital as too new, leading them to turn to growth equity as the just-right solution. Growth equity funds target investments in more established startups that are close to an exit opportunity, usually an IPO or strategic sale, typically 3-5 years or, in some cases, 1-3 years from exit.
Sweet Spot of Growth
Growth equity serves to provide investors access to higher growth opportunities compared to buyout since these companies focus on innovative products. However, unlike venture capital, these targeted companies have a fully baked product that has been successful with consumer adoption.
Growth equity managers look to provide capital to increase the company’s market share and advise on a potential exit opportunity. Given the company needs assistance on future operations, the growth equity managers structure their investment as a hybrid control stake, which provides the founder with the majority control and offers the manager a way to guide the company.
In VC, managers are taking on more risk with a company successfully executing their proof of concept and factor in companies being a complete loss for a failed concept. Conversely, growth equity managers aren’t modeling as severe losses in their portfolio, given the company already has a successful idea with existing consumers.
For growth equity, the funds will typically hold their investment from 3 to 7 years, largely contingent on the maturity of the company. Target returns for growth equity range in the mid-to-high-twenties and are driven by the manager’s track record.
- Target Company: established start-up companies with a proven concept
- Need: hybrid control stake to further growth and exit
- Exit: strategic sale or IPO
- Risk of Capital Loss: Moderate
- Holding Period: 3-7 years
Conclusion
Private equity represents an expansive investment environment, which requires finding the right manager and private equity strategy to achieve a stated investment goal or objective. The private equity strategies discussed, such as buyout, venture capital, and growth equity, point to just some of the avenues available for those seeking to access private equity markets.
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