While private equity may be a “sophisticated” asset class, its defining characteristics are straightforward: PE is an ownership interest in a private company or other private asset. PE investors derive returns from capital appreciation and the growth in value of the assets held, often playing an active role in driving that growth, whether by financing acquisitions, taking public assets private as part of a long-term strategy, or restructuring balance sheets.
We have found that with a basic understanding of the attributes and goals of PE investing, advisors can help clients navigate this huge market to identify the most promising opportunities for maximizing risk-adjusted returns and diversifying portfolios. Here are three key fundamentals:
1. What a typical allocation to PE looks like. Institutions target, on average, a portfolio allocation of between 6% and 13% to PE investments in total, according to several alternative investment research firms. For individual qualified investors, though, allocations to PE can vary widely, depending on long-term investment goals, liquidity needs, and appetite for risk.
2. How investors can access PE. There are several PE options, although not all of them are feasible for retail or capital-constrained investors.
• The most popular is the private equity fund, also known as a “primary fund,” a pooled investment product structured as a limited partnership. Institutional and high-net-worth individual investors tend to prefer investing directly in portfolio companies through primary funds because they have the capital to meet high investment minimums and cope with these illiquid vehicles’ oftentimes 10-year or more capital lockup.
• Secondaries focus on buying and selling investors’ interests in primary fund investments. This route can be complex and time-consuming.
• Fund of funds, which is pooled capital for investments in a portfolio of five or more primary funds and can be beneficial for HNW families and smaller institutions. While an FOF can provide diversification with economies of scale, investors pay an extra layer of fees for this more customized, managed access — an annual management fee and a performance fee on gains in addition to fees charged by the primary funds in the pool.
• Interval funds, like many hedge funds, are continuously offered closed-end funds that offer periodic liquidity (redemptions). Their liquidity structure can be advantageous for alternative asset managers and investors.
• Direct investments in PE portfolio companies are generally limited to institutions large enough to create and manage in-house PE investment teams.
• Publicly-traded PE funds are ETFs and open-end mutual funds that seek to simulate PE fund performance by investing in shares of three types of public equity securities: publicly-traded PE firms such as KKR, public companies that are comparable to PE portfolio companies, and business development companies providing capital to PE firms. Higher expense ratios are a key drawback.
• Co-investments are widely considered the most complex of PE investment vehicles. They allow qualified investors to invest in a portfolio company alongside a PE firm without having to pay the fees charged by a fund manager.
3. How PE firms generate returns: PE firms drive returns by increasing a portfolio company’s enterprise value, which is influenced by cash flow, debt, expenses, and revenue.
Enterprise value can be calculated by multiplying earnings before interest, tax, depreciation, and amortization by a cash flow multiple. Subtracting a portfolio company’s debt from its enterprise value gives you its equity value. To produce positive portfolio company returns for investors, PE firms have three options — increase enterprise value, decrease debt, or both.
The private nature of PE investments makes it difficult to calculate historical PE-firm returns. But higher returns are generally sought — compared to other investments — because of PE’s illiquidity. Historically speaking, institutional investors have, on average, required an annual return of between 3% and 5% more than a listed equity benchmark over the course of a full investment cycle.
James Waldinger is CEO and founder of Artivest, the largest independent provider of premier alternative investment and technology solutions.