By Jérôme Zahnen, Investment Advisor – Product Specialist Private Equity, Banque de Luxembourg
As featured in LPEA Insight/Out magazine #19, September 2021.
For many years, Private Equity has clearly been a niche in the investment’s universe, its investor base being mainly dominated by large institutional investors such as pension funds, insurance companies, large banks etc. However, today, one can clearly observe a significant increase in the interest dedicated to Private Equity and a certain “democratization” is taking place with lower minimum capital requirements that allows HNWI (High-Net-Worth Individuals) to gain access to this particular asset class. Consequently, it is worth looking into the underlying drivers of this trend and the reasons why wealth managers and private individuals should consider allocating a portion of their investable assets.
Larger investment landscape
Next to the fact that there are more and more opportunities to access Private Equity, one can also observe another tendency, more specifically, the tendency that there is a decreasing number of publicly traded companies and more often than not, companies decide to stay private for the time being. All companies should have a long-term view but going public can lead to short-termism due to the pressure to publish quarterly results and to be continuously evaluated by the analysts and the market participants in general. Furthermore, being traded on a stock exchange also creates a burden due to the increased compliance and regulatory requirements that not only lead to significant costs but also consume time, time that could otherwise be used to focus on the long-term value creation strategy of the underlying business. For those reasons, among others, the number of privately held companies, including those backed by Private Equity funds, continues to grow significantly and consequently the Private Equity universe really offers its investors a way to directly support the economy. This tendency is also illustrated on the graph below:
The increase in opportunities in Private Equity, both on the access – and the industry side, suggests that this asset class is becoming less and less “niche” and much more central in the strategic asset allocation of the investors’ portfolio.
What about risk and return?
Leaving ESG criteria on the side in this article, investing is, for most part, about risk and return and Private Equity can clearly add value on both sides. On one hand, Private Equity has outperformed public markets in Europe, the U.S. in the short-, mid- and long-term during most of the past 20 years. Therefore, allocating a portion to private companies can enhance the overall expected return of your portfolio.
On the other hand, research has also proven that Private Equity has limited correlation to Public Equity and therefore clearly offers diversification benefits. Additionally, due to the absence of daily pricings of private companies, the perceived volatility is lower compared to publicly traded firms. Even though it is important to highlight that Private Equity is impacted by many of the same risk factors that influence public companies, this illiquidity feature can be especially valuable during significant market turmoil where prices of public markets risk to dive significantly and quickly as we experienced for instance in March 2020 due to the pandemic. Here the illiquid nature of a Private Equity investment can be advantageous since investors cannot exit their positions at unfortunate timings during which companies might be valued below their intrinsic value. Finally, it is safe to say that allocating a portion of your wealth to Private Equity can enhance the efficient frontier, or in other words the risk and return profile as illustrated below, of your portfolio.
Private Equity investments can also give their investors the opportunity to invest in businesses that are at different stages of the growth cycle, from early stage up to the maturity stage, something which is much more difficult via a public company investment. More specifically, VC allows for investments in early-stage companies, “Growth Capital” in companies that require capital to fund future growth and LBOs in mature businesses with foreseeable cash-flow profiles. This is especially of interest to current or former entrepreneurs that had to go through the different stages of the growth cycle with their own business, that are aware of the challenges and that want to be part of other success stories.
Diversification & “Fund Manager” selection
However, there are multiple considerations that are worth mentioning when seeking an exposure to Private Equity. More specifically, the general investment advice “do not put all the eggs in one basket” also goes for Private Equity. It is important to diversify your Private Equity portfolio on multiple levels such as vintage years, fund managers, geographies, sectors and strategies. Another essential element and in my view one of the most relevant points, “Fund Manager” selection is crucial! It is important to note that there is a significant dispersion of returns among the different Private Equity managers (and there are many of them) as illustrated below which is not the case for managers of listed equity funds, at least not to such an extent. Consequently, it is important to have access to Private Equity specialists that conduct a thorough due diligence in order to increase the probability of selecting a top quartile performing fund. Such experts are on one hand responsible for doing a comprehensive analysis of the various fund managers and monitoring the evolution of the Private Equity market in general and on the other hand advice you on the optimal strategic asset allocation of your portfolio.
That being sad it’s not all sunshine and rainbows. Even if investing in Private Equity makes sense for many investors, it’s not suited for everyone and various elements such as the illiquid nature of this particular investment need to be taken into account. A typical Private Equity fund has a fund life of 10 years and during that time span you usually cannot exit your position. So before investing you clearly need to think about your financial situation and future spending needs in order to avoid facing liquidity issues. Furthermore, it is important to verify together with your wealth manager whether an allocation to illiquid assets such as Private Equity is in line with your investor profile in order to manage your expectations.
To conclude, for investors that tick the various boxes that need to be considered when seeking a Private Equity allocation and that target long-term capital growth, Private Equity clearly has its spot in a well-diversified portfolio.