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A Look at a Growing Asset Class: Private Equity

A Look at a Growing Asset Class: Private Equity

November 20, 2023

Here is a stat that may surprise you.  According to data from the Center for Research in Security Prices at the University of Chicago, the number of publicly listed companies traded on U.S. exchanges has fallen from a peak in 1996 of 8,000 to a count today around 3,700.* 

That decline is not due to there being less companies.  Instead, it indicates the growing trend of companies staying private rather than going public via an initial public offering (“IPO”).  And that trend is continuing, with 2022 and 2023 seeing the market for IPOs nearly drying up completely.

With more companies opting to stay, or go, private, private equity has been able to replace the public markets for a growing number of companies and has become a major investment option for a number of investors.  With all this, should you consider adding private equity to your portfolio?

This post will explain what you need to know if you are considering a private equity investment.

Where Have All the Public Companies Gone?

While IPOs have historically been the gateway for companies to enter the public market and access capital for their growth, the complexities and costs associated with going public have led more companies to seek alternative funding and growth strategies.  Every situation is different, but here are some common reasons companies forego the public markets.

One common reason is control.  Once a company goes public, it is now subject to the whims of its shareholders.  By staying private, a business can remain in the hands of a few select people or families.

Another reason to stay private is that public companies are subject to the reporting requirements of the Securities and Exchange Commission ("SEC") and other regulatory agencies.  Many executives view these requirements as burdensome and often companies are required to make public sensitive information that executives would rather keep from the public domain.

Combining those two concerns, the passage of the Sarbanes-Oxley Act in the wake of the Enron bankruptcy created a new regulatory regime on publicly traded companies that includes releasing quarterly financial results.  In addition to the burden this requirement creates on the company, it also fundamentally changes the focus of the company.  Rather than focus on long-term results, growth, and returns, to appease shareholders and market watchers, a company must instead focus on returning the best quarterly numbers each and every quarter.  In other words, stock price and not necessarily business fundamentals become the sole focus.

With the ability to obtain financing from sources other than the public markets, including private equity and private credit, more companies are making the choice to either stay private or to participate in a take private transaction where they go from publicly to privately held.  This allows them to maintain control, avoid burdensome reporting requirements and oversight, and focus on long-term growth.

Enter Private Equity

As we mentioned above, companies will find that over the course of their lifecycle, they need financing for a variety of reasons.  This may be to invest in company operations, such as hiring, facilities, or technology to grow the business.  Other times, the financing may be a way to buy out existing shareholders who are looking to exit and to move on from a business.  Private equity is such an option.

At the most basic level, private equity involves making a capital investment into non-publicly traded companies, generally via the purchase of shares, or equity, in the company.  As the goal is for these shares to grow in value, these investments often come with mentorship, guidance, or even governance oversight from the investing entity.

Private equity can take several different forms, generally based on where a company sits in its life cycle.  The 3 main forms of private equity are:

1. Venture Capital: Venture Capital, or VC, is a type of private equity investment made in early-stage companies.  VC will provide a certain amount of seed funding for a company in exchange for shares in the company (generally less than a majority stake making the funding attractive to investors).  Since these companies do not have a long track record and generally have not shown the ability to earn a profit, this type of investing tends to be the most inherently risky.

2. Growth Equity: Growth Equity involves investment in established, growing companies.  These companies are established but need funding to grow.  Again, the investment involves the purchase of shares in the company, generally representing a minority stake.  Given these companies have a track record, investors can examine financial records, interview clients, and engage in other research that helps them determine whether an investment is sound.  In addition, investors will require a growth equity investment target to have outlined what the funding will be used for and how that will help increase return on investment.

3. Buyouts:  Buyouts involve mature companies that are either already publicly traded or which are large private companies.  In these investments, the investor is generally purchasing a majority stake, if not nearly all, of the target company while existing shareholders are taking a payout and exiting the company.  A popular variation on a buyout is a leveraged buyout where the purchase price for the transaction is provided by loans which use the company itself as collateral.

One caveat to note – private equity investing is not easily accessible for the average investor.  In fact, most private equity money comes from institutional investors, such as pension funds, sovereign wealth funds, endowments, insurance companies, and family offices.

Most private equity investing is not done directly, but rather via private equity funds – a pooled investment vehicle where an adviser raises money from investors, pools it together, and then makes investments on behalf of the fund.  Only accredited investors and qualified clients, as defined by the SEC, are permitted to invest in these funds.  Furthermore, the investment minimums for these funds can be quite high, with some firms requiring $25 million or more to invest.  However, some newer funds have minimums as low as $250,000.

Benefits of Private Equity Investments

From an investor’s perspective, there are three main benefits from investing in private equity.

First, as an alternative asset class, private equity provides diversification to a portfolio by adding an uncorrelated asset to help mitigate against market risk.  In other words, as private companies do not necessarily move together with stock markets, they offer protection when markets sour and provide low or negative returns.

Returning to our discussion of the declining number of publicly traded companies, an outcome of this trend is that public markets are much more susceptible to large swings based on the stock price of a handful of companies. For example, 15% of the S&P 500 is represented by just two stocks – Apple and Microsoft.**  Private equity can help offset this volatility.

Second, private equity has the ability to provide higher returns than other assets classes.  The U.S. Private Equity Index provided by Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020.  During that same time frame, the Russell 200 Index, a performance tracking metric for small companies, averaged 6.69% per year, while the S&P 500 returned 5.91%.*** 

Third, private equity offers the ability to access upcoming institutional-quality offerings before they become widely available to the public. This exclusivity allows investors to tap into a diverse range of well-known names or up-and-coming companies, providing a front-row seat to potential market leaders. 

Risks of Private Equity Investments

The above listed benefits do not come without their own risks and tradeoffs.  A high degree of risk tolerance and the ability to handle substantial illiquidity are necessary for success in private equity markets.

Investing in private equity generally means accepting a long-term horizon for your investments as many private equity advisers have lock-up periods for their funds.  This means investors cannot access the capital they have invested in these funds for a predetermined period, sometimes as much as ten years.  Therefore, an investor needs to be comfortable accepting the illiquidity of this type of investment.

In addition to illiquidity, returns are not guaranteed.  The flip side of higher returns tends to be higher risk, especially when talking about companies in the earlier stages of their life cycle. 

It is also imperative to understand that an investment in a private equity fund might not be a one-time action.  Once committed to a fund, the adviser may make periodic capital calls to fund new or additional investments in portfolio companies.  Investors need to have the available liquidity to fund these calls.

Do Your Homework

While this piece largely focuses on investing via a fund, there are opportunities for direct investment in private companies, particularly very early-stage companies via angel or so-called “friends and family” investment round. 

Given the nature of private equity investments, a thorough due diligence process is critical. With information not readily available to the public, investors must carefully assess the financial health, management team, and growth potential of the companies in which they plan to invest. This diligent approach helps measure and manage risks, returns, and potential capital calls, ensuring a well-informed investment strategy.

And investing via a private equity fund doesn't end the need for diligence.  Before investing, make sure you understand a fund’s strategy and investment process.  Look at the adviser and examine the performance of their other funds, particularly their rate of return compared to other funds and the types of portfolio companies in those funds. 

Finally, fees.  Private equity funds typically charge both an annual management fee and a carried interest fee. Make sure you understand how these fees are charged so that you can accurately compare different funds. Also, keep in mind that high fees do not necessarily mean high returns. Sometimes, it is actually the opposite.

Conclusion

Investing in private equity offers a unique opportunity to be part of a growing trend in the business world. As more companies choose to stay private, investors can gain access to a diverse range of investment opportunities. While the non-liquid nature of these investments and the need for careful due diligence present challenges, the potential for higher returns and the chance to participate in the growth of tomorrow's industry leaders make private equity an attractive and dynamic space for investors willing to explore beyond traditional investment avenues.

With over 25 years of success serving successful Business Owners, High Income Earners, Family Offices, and Strategic Partnerships, our platform offers access to unique investment opportunities that appeal to the more mature palate of larger accredited investors and qualified purchasers looking for greater diversification.  If investing in private equity is of potential interest, call us.  We can help.

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*CSRP US Stock Database. Available at: https://www.crsp.org/research/crsp-us-stock-databases/

**"S&P 500’s Tech-Heavy Top Is a Feature, Not a Bug" by Nir Kaissar for Bloomberg.  Available at: https://www.bloomberg.com/opinion/articles/2023-06-08/personal-finance-s-p-500-s-tech-heavy-top-is-a-feature-not-a-bug

***https://www.cambridgeassociates.com/wp-content/uploads/2022/05/WEB-2021-Q4-USPE-Benchmark-Book.pdf