Investing in Private Equity

 

What is Private Equity?

Private equity refers to investments in privately owned companies that are not listed on public stock exchanges. These companies can cover all stages of development, from innovative start-ups seeking growth capital to buyouts of established businesses.

For investors, private equity offers the opportunity to participate in these companies' growth journeys, often alongside professional investment managers. Returns are typically realised over long term horizons, usually five to ten years, through strategic exits such as initial public offerings (IPOs), mergers, or acquisitions by trade or secondary buyers. This patient capital allows companies to focus on sustainable growth without the pressures of short term public market performance.

Private equity has emerged as an important component of modern investment portfolios for many investors, offering access to high growth businesses, the potential for superior returns, and a means of diversifying risk. Traditionally reserved for institutional capital, private equity is becoming increasingly accessible to experienced investors, family offices, and, through recent innovations, certain retail investors. This guide provides a detailed look at private equity investment, focusing on its fundamentals, evolving accessibility, benefits, risks, and strategies investors deploy to maximise its potential within a well-constructed portfolio.

Who Can Invest in Private Equity?

Historically, private equity has been dominated by institutional investors such as pension funds, insurance companies, and endowments. Over time, the sector has expanded to include HNWIs and family offices, who recognised the capability of the asset class potential for superior returns and diversification.

More recently, regulatory and structural changes have begun to democratise access to private equity, with the Long Term Asset Fund (LTAF) being an example of this shift within the UK. Introduced by the FCA, LTAFs provide access to illiquid investments such as private equity for certain types of retail investors. These funds are designed to balance investor protection and liquidity while maintaining the longer term horizons typical of private equity.

Although retail participation remains limited, it represents an important development in the evolution of private equity. Innovations such as LTAFs indicate how the market and regulators are adapting to accommodate a broader spectrum of investors.

Developing a Private Equity Investment Strategy

A successful private equity strategy requires careful planning and a clear understanding of its role within a broader portfolio. For most, private equity will serve as a diversification tool, offering returns that are uncorrelated to public market movements.

Investors must first define their financial goals and risk appetite. Private equity typically involves committing capital for extended periods, often exceeding five years. Allocations should reflect this long term commitment, with advisors such as JP Morgan recommending clients devote no more than between 15% and 30% of their investible funds in alternatives, depending on their individual circumstances.

Deciding between fund investing and deal-by-deal investing is also an important decision as each have two very different models. Funds provide professional management and diversification but limit investor control. As soon as the Limited Partner (LP) has committed the capital, the General Partner (GP) has full discretion on how and when that capital is used. This can appeal to investors seeking professional oversight but without direct involvement and investors who are comfortable with the manager’s discretion in deploying capital.

Deal-by-deal investing is a different strategy to the traditional pooled fund, putting the investor in control of how and where their money is invested. Investing alongside a professional private equity manager, investors self-select opportunities and tailor their allocations to specific industries, their financial goals and risk profile. As single-asset investments, rather than a portfolio of companies, there is earlier return potential.

According to Goldman Sachs, 59% of limited partners plan to increase their allocations to co-investments over the next 2–3 years, reflecting growing demand for selective, transparent private equity strategies.

How to Invest in Private Equity

Investors can access private equity in several ways, each with its unique characteristics:

Private Equity Funds

As previously mentioned, the traditional model involves pooled funds managed by experienced professionals who allocate capital across a portfolio of companies. This approach diversifies risk but limits investors' ability to choose specific investments.

Deal-by-Deal Co-investment

Increasingly popular, this structure allows investors to select individual opportunities on a case by case basis. Deal-by-deal investing offers greater transparency and control, enabling investors to target sectors or businesses that align with their strategic goals.

Listed Private Equity Vehicles

Publicly traded private equity trusts provide an alternative for those seeking liquidity. While these vehicles offer exposure to the asset class, their returns are often more closely tied to stock market performance than traditional private equity investments.

Emerging Platforms and Crowdfunding

Technology-driven platforms have further opened the doors to private equity, allowing smaller investors to co-invest. However, these options require thorough due diligence to assess risks and alignment with investment objectives.

Advantages and Disadvantages of Private Equity

Private equity is renowned for its compelling benefits but also comes with challenges that require careful consideration.

Benefits

Private equity has consistently delivered superior returns compared to public markets. For example, private equity funds managed by BVCA members achieved an annualised return of 17% over a decade, significantly outperforming the FTSE All Share Index at 6.5%.

Source: BVCA Performance Measurement Survey 2022.

The asset class offers greater diversification, especially where popular funds like the S&P 500 have more than 20% of its market capitalisation concentrated on just five US tech companies. Private equity’s low correlation with public equities helps mitigate portfolio volatility, making it particularly attractive during periods of market uncertainty.

The UK is one of Europe’s leading tech ecosystems, and private equity provides access for investors to exciting companies within this dynamic landscape across high growth sectors such as healthcare, software and technology. Many PE backed businesses are at the cutting edge of emerging technologies or disrupting traditional markets which are ripe for change, offering significant growth opportunities.

Challenges

The private equity industry currently holds near record levels of dry powder exceeding $2.6 trillion globally. This surplus capital will create pressure to deploy funds, inflating valuations in sought-after sectors like technology. For investors, this environment underscores the importance of selecting fund managers who can identify proprietary deals or have the value creation capabilities to enhance returns through operational improvements, rather than overpaying for assets.

Source: S&P Global Market Intelligence.
*Year to date through July 10, 2024.

Sustained higher interest rates have also fuelled the cost of debt, presenting another potential challenge to both businesses and private equity managers. However, well-capitalised firms with multiple financing streams and less reliant on leverage will feel this effect less. By aligning with managers with a reputation for prudence, adaptability, and strong governance, investors can navigate these complexities to capitalise on the assets long-term growth potential.

Assessing Private Equity Risks

Private equity offers compelling opportunities, but it is not without risks. One of the primary challenges is illiquidity. Investing in private equity requires patience and a risk tolerance to committing capital over an extended period. Unlike publicly traded stocks, private equity investments are not listed, meaning there is no active marketplace where investors can easily buy or sell their shares. In addition, many funds may have ‘lock in’ periods where investors cannot access their capital. This allows the fund to pursue its objectives without pressure to liquidate assets prematurely. While this long-term commitment may deter some, the so called ‘illiquidity premium’ can compensate investors with the potential for higher returns, often 2–5% above public market equivalents.

Like publicly listed businesses, private companies are also sensitive to economic conditions. Factors such as rising interest rates, inflation, or recessions can affect valuations and delay profitable exits. Additionally, success often depends on the ability of private equity managers to drive operational improvements and achieve growth targets, introducing execution risk. Selecting experienced managers is vital to mitigating these uncertainties.

Valuation transparency presents another challenge. Unlike public markets, private equity valuations are often subjective, based on projections and less frequent reporting. This can make it difficult for investors to track performance accurately.

As is the case with any investment, concentration risk needs to be considered. Diversifying across sectors, geographies, and stages of company growth can help manage this exposure.

Finally, investors should be aware of regulatory risks, such as evolving policies that impact tax treatment or fund accessibility, as well as fee structures, which can erode returns.

Private Equity Market Trends

One significant trend is the increasing emphasis on Environmental, Social, and Governance (ESG) factors, and sustainable investment. Many institutional investors now regard ESG considerations as essential rather than optional. Pension funds and other institutions now require fund managers to integrate ESG principles into their investment strategies and oversight of portfolio companies. Some investors even exclude managers who do not meet these standards, positioning ESG as a pivotal element in fund selection and overall strategy.

The dynamic ESG landscape brings heightened regulatory pressures affecting both PE firms and their portfolio companies, requiring an enhanced knowledge of ESG in PE firms in order to support portfolio companies. Integrating ESG principles into commercial decisions can be a massive driver of value add and allow portfolio companies to stand out from competitors. PE firms must enhance portfolio engagement to ensure companies are aware of the benefits, have the resources in place to implement sustainable strategies, and ensure firms remain compliant with new regulations and industry expectations around ESG.

Exit activity is beginning to recover following a recent slowdown, with increased political and economic stability encouraging firms to consider sales. Additionally, the adoption of artificial intelligence (AI) is transforming deal sourcing, portfolio management, and operational efficiencies. By utilising advanced analytics and predictive tools, AI can enhance decision-making, optimise resource allocation, and potentially lead to improved returns. This digital transformation may be an attractive option for forward-thinking investors.

Conclusion

Private equity remains a dynamic and rewarding asset class for experienced investors willing to embrace its complexities to benefit from its unique qualities. With the potential for superior returns, portfolio diversification, and access to innovative sectors, it offers a compelling alternative to traditional investments.

However, private equity requires careful planning, a disciplined approach, and long-term commitment. As the sector continues to evolve, through innovations like LTAFs and deal-by-deal opportunities, it is becoming an increasingly essential component of modern investment strategies. For those equipped to navigate its nuances, private equity provides a strong opportunity to achieve long-term financial success.