Private equity: Mighty oaks from little acorns grow

Private equity (PE) has stepped into the spotlight over the last decade. Despite the fallout from the global financial crisis, the industry has managed to deliver compelling returns over a difficult period, enjoyed impressive asset growth and attracted investors into what was once viewed as a relatively niche asset class.​

A brief history of PE

Investors have been buying private companies for hundreds of years. Some of the most eminent names in finance, including JP Morgan, the Rockefeller, Vanderbilt and Warburg families, generated their wealth from private investments across industries as diverse as railroads, steel, property and mining.

The modern PE industry emerged in the 1980s when leveraged buyouts were considered high risk. The 1989 book ‘Barbarians at the Gate’ portrayed PE managers as a new, disruptive breed of investors who were upending Wall Street’s expectations of how deals should be done.

But since then the industry has evolved into a valuable participant in the financial ecosystem which restructures and repurposes underutilised assets, provides capital for growth and takes on challenges beyond the patience of public markets.
 

Part of the establishment

Today PE is everywhere. It is involved in getting the latest venture capital start-ups off the ground in Silicon Valley, reinvigorating older more established businesses and funding growth across all sectors of the economy while generating impressive returns.

Few could have predicted the incredible rise of the PE sector over the last 30 years. PE partners have shed their reputation as corporate raiders. Indeed, many company owners seek PE investment as a way to transition their businesses to a new phase of growth, and relationships between company management and PE firms tend to be collaborative, amicable and mutually beneficial.

Along with their cheque book, PE firms bring a wealth of experience and strategic purpose. So in addition to making money for their own investors, PE firms have been shown to strengthen their portfolio companies, leaving them more profitable and resilient after they have sold them on.

Growth has been impressive

The PE industry has also grown exponentially since the 1980s. While only a few hundred million dollars were committed to a handful of managers back then, today thousands of managers raise combined commitments of over $400 billion annually. When this is combined with investment performance, the sector was worth well over $2 trillion dollars by mid-2016.

However, some of the original players still dominate the industry, with much of this investment directed by key players like David Rubenstein at The Carlyle Group, Steve Schwarzman at Blackstone and Henry Kravis at KKR. These veterans have survived because they are very good at what they do, minimising their mistakes, and keeping their investors happy over multiple economic and business cycles. Alongside these giants, other niche managers have developed more specialised strategies, catering to sectors as diverse as financial technology, biotechnology and education.

Table 1: Top 10 PE firms by capital raised from January 2012 - April 2017, in $ billions

Source: Ernst Young
 

Investors increasing allocations to private investments

Some of the largest and longest-standing PE investors are big US pension and university endowment funds. For many years these funds have dedicated a significant portion of their investment programmes to alternative investments, including PE. These institutions believe that adding PE to portfolios increases expected performance and produces returns not highly correlated to equity markets. The $25 billion Yale Endowment Fund targets a 31% allocation in corporate PE – 15% leveraged buyout and 16% venture capital - as a result of the asset class’ “extremely attractive long-term risk-adjusted returns” (Figure 1). More recently, other groups of investors, including sovereign wealth funds have followed suit, reorienting portions of their portfolios away from public markets towards private opportunities.

Figure 1: Yale Endowment Fund asset allocation, in %

Source: Yale Endowment Funds

Figure 2: Private equity versus public equity returns

Source: Cambridge Associates
Note: Cambridge Associates LLC US Private Equity Index compared with S&P 500. Figures shown are total returns net of fees, expenses and performance fees.

It pays to go private

And we can see why. The internal rate of return on these investments clearly beats public stock markets and the excess returns add up (Figure 2). The level of debt employed at the outset of a leveraged transaction is undoubtedly a factor in this outperformance. But there are other reasons PE investments have done well relative to their listed counterparts.

• Opportunities everywhere: PE investors are not confined to investing in listed companies. Hundreds of thousands of large, attractive businesses exist outside of the stock markets. The opaque nature of these private companies creates opportunities. While pools of analysts pore over the balance sheets and earnings of public companies, the strengths and weaknesses of private companies may be virtually unknown to all but their owners. And there is a valuation discount for the illiquid nature of the investment, so it can be easier to unearth attractively valued investments in private markets.
• A force for change: A company’s new owners can make changes to drive earnings growth. One of Davy’s PE partners’ philosophy is that “companies can always be improved, everywhere, at all times”. Leveraged buyout managers get into the nitty gritty, day-to-day details of running the company and make operational improvements. For example, increasing sales and marketing efforts or reducing costs by streamlining purchase programmes. At a higher level, strategic repositioning, such as expanding a product line or moving into international markets, can improve a company’s top line.
• More nimble: Privately-held companies are typically more nimble and can make more dramatic changes than listed companies. Equity markets can be fickle and CEOs (chief executive officers) find it difficult to execute longer-term transformations while also focusing on quarterly targets. In 2013 when Michael Dell decided to strategically overhaul Dell, he assembled a consortium of private investors and lenders to take the company private. These investors buy-in to the transformation thesis and are willing to take a longer-term view with the aim of achieving superior results.

Caveat emptor

Of course every investment is not without risks and PE is no exception. Before making an investment in a PE fund there are a number of factors to consider. Time is both an asset and a liability and PE investing requires patience as in most cases funds are tied-in for more than 10 years so investors need to ensure they can lock their money away for an extended period. Compared with equity investment, PE investment is a more complex and involved process and as a result it involves higher fees than listed equity investment, including performance-related fees. PE investment sits relatively high on the risk spectrum and – as with the Yale Endowment’s portfolio – should be considered as part of a balanced portfolio.

The future for PE

The future for PE looks bright. High and consistent returns illustrate an interesting facet of the asset class: PE managers invest throughout the cycle, putting money to work in bad times as well as good. In the aftermath of the global financial crisis, PE firms were extremely active in capitalising on the broader market’s overly negative sentiment. This cool-headed approach has borne superior returns in the period since then.

The equity bull market is now entering its ninth year, and given some of the more robust valuations seen in parts of the markets a number of our PE partners have reported slower, more cautious investment activity. They're spending more time rooting out opportunities with good valuations. As investors globally wonder if there will be continued strong growth in equities, and with bond and bank deposit yields so low, now could be a good time to consider the merits of going private.