Thursday 18th July 2019
What to look for in private equity?
By Andrew McAuley , Chief Investment Officer, Credit Suisse Private Bank
After a period of good returns from equities and bonds, and with the official cash rate at 1.0%, many investors are looking for ways to reduce risk and diversify their portfolios. Adding alternative investments such as private equity is one of the ways to do this. Alternative investments are any asset other than stocks, bonds, and cash, and which can act as building blocks to diversifying portfolios. Hedge funds, commodities, and real estate are all considered part of the alternative investments universe, not to mention private equity.
Private equity funds take equity stakes in companies or assets that are not publicly traded and work closely with the management teams to increase their value to be able to sell it again at a higher price. Thus, by their nature they are less correlated with equity and bond markets, as value realisation depends on restructuring and effective management and not investment market movements. Investors, mostly institutional and high-net-worth individuals, can put their money to work in a different way, as an alternative to buying stocks in companies that are listed on public markets. The investments can be used to finance startups (venture capital), inject working capital into a growing company (growth capital), acquire a mature company for growth or reshaping (buy-out), or purchase assets or loans that are in distress and need refinancing (special situations/distressed debt).
The potential for generating returns
Private equity tends to outperform public markets. This is driven by the fact that these assets are privately held, allowing managers more time and control to implement value-creation strategies. An important factor to investors in creating excess return is the selection of best-in-class, hard-to-access fund managers. This, however, requires a disciplined due diligence process and access to a broad network of high-performing funds. Going one step further, the various strategies under private equity can each present interesting opportunities as well as different risk reward profiles.
The growing capital allocation into this asset class has enabled the growth of many other strategies on top of the traditional buyout and growth ones. Other strategies include secondaries, infrastructure as well as special situations strategies, as a way to diversify exposure to private equity. The secondaries market is where established players buy private equity positions from investors looking to exit their investment before maturity. There are listed private equity managers, whose performance can be used as a rough proxy for performance of the sector, although their volatility is not a good comparison for unlisted private equity itself, which provides a smoother return profile.
Performance of Listed Private Equity, Hedge Funds, Stocks and Bonds
Source: Bloomberg, Credit Suisse, last data point July 9, 2019.
Investing in private equity
Investments in private equity should be globally diversified across funds, strategies and most importantly, vintages. The latter refers to the year in which the fund makes the first investment. Unlike investments in traditional asset classes, the commitment in private equity is gradually drawn over the investment period (anywhere between three and five years) and does not require an upfront investment of the entire amount. Over time, investors should aim to build a self-financing private equity portfolio that has sufficient distributions to cover future capital calls. The approach we advocate is for clients to gain exposure to the private equity space through a basket of funds diversified across strategy, geography and vintage, putting together a portfolio of well-performing managers.
Each of the managers tap the respective strategies of private equity, and can offer clients a comprehensive solution without them going through the often tedious process of due diligence themselves. Preferably each vintage is an annual series, so clients can pace their commitment into this asset class, and achieve better cashflow over time. Another emerging strategy is to invest directly into the private equity manager. This enables investors to access a suite of unlisted private equity managers to participate in the carry on the performance of the underlying portfolio and to share in the performance of the manager.
A common barrier to enter this asset class, given the scale of the investment and funds, is the relatively large commitment size required from investors. While most institutional investors would have no difficulty accessing funds directly, the usual commitment size required could potentially pose a barrier for private clients to participate. But feeder structures are available where the minimum commitment is lowered to a more digestible size. The other barrier is liquidity in the first 3 to 5 years of the investment is often limited or non existent. However, the secondaries market can provide liquidity, although often at a discount. But for investors who can confidently forecast their cash flow requirements and can take a long term view for part of their portfolio this is not an issue. Interestingly, following the example of the Future Fund and Industry Super Funds, we have individual and not for profit clients increasingly committing to such investments, which was a much rarer occurrence just a few years ago.
We believe that strategies in private assets, especially private equity, present good opportunities for investors who are keen to seek diversification from the public markets.
Credit Suisse, unless otherwise specified.
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