The private equity market is bigger than ever, with Preqin pegging global assets under management at an all-time high of $2.49 trillion. And it has historically outperformed other asset classes over the long term — so it’s not surprising that investors are eager to tap into it. But like any other type of investment, private equity opportunities can be risky and must be thoroughly evaluated.
Some private equity investments have a greater chance of boosting an investor’s portfolio performance than others. Silicon Valley continues to flood the market with news stories about venture capital investments in startups and seed capital investments in companies still in the research-and-development stage. However, as new and unproven companies in saturated industries like fintech and biotech, they present investment opportunities which are risky and unlikely to deliver the returns and diversification that investors are pursuing.
To provide greater returns and downside protection for investors interested in adding private equity to their portfolios, advisors should consider steering clients toward investments in growth-stage companies that are already producing income and demonstrate strong growth prospects.
Companies in the first stage of development — R&D — have no profits or consistent cash flow, and can’t be certain that they will even have a product to sell. Firms that have passed the R&D phase and entered startup territory have a product to sell, but lack the infrastructure to mass-produce their product and deliver it to their full customer base.
R&D and startup companies with no or few assets, and no track record of generating income, have a much higher risk of failure than growth-stage companies, and haven’t evolved to the point where they are able to deliver predictable or steady returns to investors.
On the other hand, more mature companies that have demonstrated their ability to produce income and expand, but need additional capital to reach the next stage of growth, can quickly begin delivering distributions to investors.
When evaluating potential private equity investments in growth-stage firms, advisors and their clients should make sure the companies meet the following four criteria before investing:
- Current and Sustainable Yield: Companies that already generate returns, and show signs of being able to continue to do so going forward, have the best likelihood of delivering distributions over the long term.
- Proven Operating Partners/Management Team: If the operating partners and/or management team that helped build up a promising growth-stage company to its present state will remain with the firm, and retain a minority ownership stake, then the company is on the right track to meeting its goals for expansion while remaining profitable.
- High Barriers to Entry: An income-producing company that operates in an industry where new competitors can’t easily crop up has a much lower risk of disruption, giving it a good chance of growing its operations and market share going forward.
- Recession-Resilient: A growth-stage company that operates in an industry that has historically not experienced a decline in consumer demand during economic downturns is likely to remain profitable regardless of market conditions.
Wonder at the Possibilities
The Cambridge Associates Global Private Equity & Venture Capital Index, which measures global private equity performance, not only generated higher returns than the S&P 500 index between October 1995 and September 2015, but did so with about half of the volatility. Data from Cambridge Associates, FactSet and Voya Investment Management demonstrates that a portfolio with private equity in addition to stocks and bonds performed better than traditional 60/40 portfolios after the dot-com bubble burst, and during the 2008-2009 financial crisis.
However, not all private equity investments are capable of providing investors with these benefits. In order to give their clients the best chance to achieve greater returns and diversification, advisors should consider encouraging them to invest in more mature companies that have already demonstrated the ability to potentially perform well over the long term.