Why and How to Invest in Private Equity
Introduction and Background to the
Private equity has arrived as a major component of the
alternative investment universe and is now broadly accepted
as an established asset class within many institutional
portfolios. Many investors still with little or no existing
allocation to private equity are now considering establishing
or significantly expanding their private equity programs.
Private equity is often categorized an "alternative
investment", comprising a variety of investment techniques,
strategies and asset classes that are complimentary to
the stock and bond portfolios traditionally used by investors.
chart shows the main components of the alternative
investment space at a broad level.
Definition of private equity
Private equity investing may broadly be defined as "investing
in securities through a negotiated process". The
majority of private equity investments are in unquoted
companies. Private equity investment is typically a transformational,
value-added, active investment strategy. It calls for
a specialized skill set which is a key due diligence area
for investors' assessment of a manager. The processes
of buyout and venture investing call for different application
of these skills as they focus on different stages of the
life cycle of a company.
Private equity investing is often divided into the categories
described below. Each has its own subcategories and dynamics
and whilst this is simplistic, it provides a useful basis
for portfolio construction. In this article, private equity
is the universe of all venture and buyout investing, whether
such investments are made through funds, funds of funds
or secondary investments.
Venture capital is investing in companies that have
undeveloped or developing products or revenue.
- Seed stage Financing provided to research,
assess and develop an initial concept before a business
has reached the start-up phase.
- Start-up stage Financing for product development
and initial marketing. Companies may be in the process
of being set up or may have been in business for a short
time, but have not sold their products commercially
and are not yet generating a profit.
- Expansion stage Financing for growth and expansion
of a company which is breaking even or trading profitably.
Capital may be used to finance increased production
capacity, market or product development, and/or to provide
additional working capital. This stage includes bridge
financing and rescue or turnaround investments.
- Replacement Capital Purchase of shares from
another investor or to reduce gearing via the refinancing
- Buyout A buyout fund typically targets the
acquisition of a significant portion or majority control
of businesses which normally entails a change of ownership.
Buyout funds usually invest in more mature companies
with established business plans to finance expansions,
consolidations, turnarounds and sales, or spinouts of
divisions or subsidiaries. Financing expansion through
multiple acquisitions is often referred to as a "buy
and build" strategy. Investment styles can vary
widely, ranging from growth to value and early to late
stage. Furthermore, buyout funds may take either an
active or a passive management role.
- Special Situation Special situation investing
ranges more broadly, including distressed debt, equity-linked
debt, project finance, one-time opportunities resulting
from changing industry trends or government regulations,
and leasing. This category includes investment in subordinated
debt, sometimes referred to as mezzanine debt financing,
where the debt-holder seeks equity appreciation via
such conversion features as rights, warrants or options.
What are the main sources of private equity finance?
The spectrum of investors in private equity has expanded
rapidly to include different types of investors with significant
long-term commitments to the asset class. The majority
of commitments to private equity funds based in respective
geographical regions have come from institutions within
the same region. This is evolving as investors seek a
higher level of geographical diversification in their
private equity portfolios.
Why Invest in Private Equity?
The fundamental reason for investing in private equity
is to improve the risk and reward characteristics of an
investment portfolio. Investing in private equity offers
the investor the opportunity to generate higher absolute
returns whilst improving portfolio diversification.
Long-term historical out-performance
The long-term returns of private equity represent a
premium to the performance of public equities. This has
been the case in the US for over 20 years and also in
Europe, following an increase in the number of private
equity funds, for over 10 years. For many institutions,
such a premium over more conventional asset classes justifies
the different risk profile of the asset class.
True stock picking in a low inflation, low growth
A low inflation environment creates a focus on growth
stocks as a means of out-performance. One of the core
skills of the successful private equity manager is to
pick companies with growth potential and actively to create
the conditions for growth in those companies. Since private
equity funds own large, often controlling, stakes in companies,
few, if any, other private equity managers will have access
to the same companies. Private equity managers are therefore
true "stock pickers". This contrasts to mutual
funds, which will often hold largely the same underlying
investments as their peer group, with variations in weightings
being fine-tuned to a few basis points.
Excessive volatility and poor investment performance
experienced by quoted equity portfolios, many of which
have index-tracking strategies or are benchmarked to an
index ("closet trackers"), have led to a swing
in favor of strategies that seek absolute returns.
Demographic trends have compounded the desirability of
such a change. The need to provide for an ageing population
has obliged many institutions to adopt a more absolute
return oriented investment approach in order to meet future
liabilities. Private equity managers do seek absolute
returns and their traditional incentivisation structure,
the "carried interest", is highly geared towards
achieving net cash returns to investors.
Portfolio diversification improves risk and volatility
Within a balanced portfolio, the introduction of private
equity can improve diversification. Although lower correlation
of returns between private equity and public market classes
is widely debated and needs further investigation, the
numbers do indicate a lower correlation.
Exposure to the smaller companies market
The private equity industry has brought corporate governance
to smaller companies and provides an attractive manner
of gaining exposure to a growth sector that went out of
favor with market investors in the mid 1990s for reasons
Access to legitimate inside information
A much greater depth of information on proposed company
investments is available to private equity managers. This
helps managers more accurately assess the viability of
a company's proposed business plan and to project the
post-investment strategy to be pursued and expected future
performance. This greater level of disclosure contributes
significantly to reducing risk in private equity investment.
Equivalent information in the public markets would be
considered "inside information". By definition,
investors in public markets will know less about the companies
in which they invest.
Ability to back entrepreneurs
The wider emergence in Europe of entrepreneurs as an
important cog in the economy has been facilitated by a
period of larger company rationalization. This has reflected
similar developments in the US that, for example, fostered
rapid growth in technological innovation and substantial
knock-on benefits for the whole economy through the 1990s.
Entrepreneurs have also been at the heart of developments
in Europe, creating value in both traditional and hi-tech
industries. The private equity asset class offers the
ability to gain investment exposure to the most entrepreneurial
sectors of the economy.
Influence over management and flexibility of implementation
Private equity managers generally seek active participation
in a company's strategic direction, from the development
of a business plan to selection of senior executives,
introduction of potential customers, M&A strategy
and identification of eventual acquirers of the business.
Furthermore, implementation of the desired strategy can
normally be effected much more efficiently in the absence
of public market scrutiny and regulation. This flexibility
represents another feature whereby risk can be reduced
in private equity investment.
Leveraging off balance sheet
Buyout managers in particular are able to make efficient
use of leverage. They aim to organize each portfolio company's
funding in the most efficient way, making full use of
different borrowing options from senior secured debt to
mezzanine capital and high yield debt. By organizing the
company's funding requirements efficiently, the equity
returns are potentially enhanced. In addition, because
the leverage is organized at the company level and not
the fund level, there is a ring-fencing benefit: if one
portfolio company fails to repay its borrowing, the rest
of the portfolio is not contaminated as a result. Thus
the investor has the effective benefit of a leveraged
portfolio with less downside risk.
However, there are features that investors might not
find attractive and which must be understood.
- Long-term investment In general, holding periods
between investment and realization can be expected to
average three or more years (although this may be shorter
when IPO markets are especially healthy). Because the
underlying portfolio assets are less liquid, the structure
of private equity funds is normally a closed-end structure,
meaning that the investor has very limited or no ability
to withdraw its investment during the fund's life. Although
the investor may receive cash distributions during the
fund's life, the timing of these is normally uncertain.
"Liquidity risk" is one of the principal risk
characteristics of the asset class. Private equity should
therefore be viewed as a longer-term investment strategy.
- Increased resource requirement As a result
of the active investment style typical of the industry
and the confidentiality of much of the investment information
involved, the task of assessing the relative merits
of different private equity fund managers is correspondingly
more complex than that of benchmarking quoted fund managers.
This makes investment in private equity funds a much
more resource-intensive activity than quoted market
investment. Likewise, postinvestment monitoring of funds'
performance is also more resource-intensive. Resource
is a key issue in the development of a private equity
program that is suitable for the investor.
- "Blind pool" investing When committing
to a private equity fund, the commitment is typically
to provide cash to the fund on notice from the general
partner. Whilst launch documentation will outline the
investment strategy and restrictions, investors give
a very wide degree of discretion to the manager to select
the companies that the investors will have a share in.
Unlike some real estate partnerships, there is usually
no ability at the launch of a private equity fund to
preview portfolio assets before committing, because
they have not yet been identified. Also, there is generally
no ability to be excused from a particular portfolio
investment after the fund is established.
Approaches to Portfolio Construction
Portfolio construction will reflect the principal objectives
of investing in private equity, including targeting higher
long-term returns and portfolio diversification through
reduced correlation to public equity markets. Issues of
correlation will apply not only in connection with other
assets, but also amongst the assets in the private equity
Decision 1 - The size of the private equity allocation
Investors in private equity should be able to accept
the illiquid character of their investment, hence the
extent to which liquidity may be required is often a factor
in the size of allocation. For this reason, it is often
the case in the US that the investors who make the largest
proportional allocations to private equity from their
overall portfolios are those who are able to invest for
the long term with no specific liabilities anticipated.
These would include endowments, charities and foundations.
Pension funds also are often large investors in the asset
class. Based on the requirement to increase targeted returns
and/or reduce volatility, the investor will determine
the proportion of its overall portfolio that it believes
is appropriate to allocate to private equity.
Decision 2 - Number of private equity funds to commit
It is a challenge for investors to avoid concentration
of risk within their private equity portfolio and to control
portfolio volatility. It is appropriate to aim for some
diversification. The chart below indicates that a level
of diversification can be achieved by holding at least
6 different funds.
Decision 3 - Ways of achieving diversification
- Stage There is negative correlation between
returns from different stages of private equity. Diversification
can therefore reduce risk within a private equity portfolio
and this should be an important consideration.
- Geography Geographical diversification can
be secured in Europe through the use of country-specific,
regional and pan-European funds. Non-European exposure
is also widely available, in particular through US funds,
but also for example through Global, Israeli, Latin
American and Asian funds.
- Manager Selecting a variety of managers will
reduce manager specific risk.
- Vintage year Timing has an impact on the performance
of funds, as opportunities for investment and exit will
be impacted by external economic circumstances. For
this reason it has become a normal practice to compare
the performance of funds against others of the same
vintage. There may be marked differences in performance
from one vintage year to another. In order to ensure
participation in the better years, it is generally perceived
to be wiser to invest consistently through vintage years,
as opposed to "timing the market" by trying
to predict which vintage years will produce better performance.
- Industry In venture investing, most of the
focus tends to be on technology based industries. These
can be subdivided, for example into healthcare / life
sciences, information technology and communications.
Buyout funds tend to focus on technology to a lesser
extent, providing exposure to such sectors as financial
institutions, retail and consumer, transport, engineering
and chemicals. Some have a specific sector focus.
Decision 4 - How to implement the strategy
Given the typical minimum investment size of private
equity funds, establishing a diversified portfolio will
require certain minimum levels of capital commitment.
It will also take time to put into effect, bearing in
mind vintage year diversification and the over-riding
objective to identify the best managers in a given area.
Decision 5 - How to plan for the volatility of cash
flows - the J-curve
An investor is typically required to fund only a small
percentage of its total capital commitment at the outset.
This initial funding may be followed by subsequent drawdowns
(the timing and size of which are generally made known
to the investor two or three weeks in advance) as needed
to make new investments. Just-in-time drawdowns are used
to minimize the amount of time that a fund holds uninvested
cash, which is a drag on fund performance when measured
as an internal rate of return ("IRR"). Investors
need to maintain sufficient liquid assets to meet drawdown
obligations whenever called. Penalty charges can be incurred
for late payment or, in extreme cases, forfeiture of an
investor's interest in the fund. In most funds' early
years, investors can expect low or negative returns, partly
due to the small amount of capital actually invested at
the outset combined with the customary establishment costs,
management fees and running expenses.
As portfolio companies mature and exits occur, the fund
will begin to distribute proceeds. This will take a few
years from the date of first investment and the timing
and amounts will be volatile.
When drawdowns and distributions are combined to show
the net cash flows to investors, this normally results
in a "J-curve", illustrated in the chart below.
As distributions normally commence before the whole commitment
has been drawn, it is unusual for an investor ever to
have the full amount of its commitment actually managed
by the manager. In the illustration below, net drawn commitments
peak at around 80%.
The Practical Aspects of Investment
Principal means of private equity investment
The principal means of private equity investment are:
- Investing in private equity funds.
- Outsourcing selection of private equity funds.
- Direct investment in private companies.
While it is sometimes the ultimate objective of investors
to make direct investments into companies, compared with
investing through funds it requires more capital, a different
skill set, more resource and different evaluation techniques.
Whilst this can be mitigated by co-investing with a fund
and the rewards can be high, there is higher risk and
the potential for complete loss of invested capital. This
strategy is recommended only to experienced private equity
investors. For most investors the use of private equity
funds would be preferred.
In-house private equity fund investment program
Investors in a fund generally expect to gain broader
exposure through a portfolio built during the commitment
period by investment professionals who specialise in discovering,
analysing, investing, managing and exiting from private
company investments. Being diversified amongst a number
of different investments helps ensure that the risk of
total loss of capital in the fund is relatively low compared
to investing directly in unquoted companies. Compared
to quoted equity funds, private equity funds often invest
in relatively concentrated portfolios, for example there
might be 10–15 companies in a typical buyout portfolio
or 20–40 companies in a venture capital portfolio.
- Fund of Funds A fund of funds is a pooled fund
vehicle whose manager evaluates, selects and allocates
capital amongst a number of private equity funds. Because
many funds of funds have existing relationships with
leading fund managers, and because commitments are made
on behalf of a pool of underlying investors, this can
be an effective way for some investors to gain access
to funds with a higher minimum commitment or to heavily
subscribed funds. Many funds of funds are "blind"
pools, meaning that exposure to particular underlying
funds is not guaranteed. Rather the investor is relying
on the record of the manager to identify and secure
access to suitable funds. Some funds of funds, however,
disclose a preselected list of investments. Investors
in funds of funds need to balance the extra layer of
management fees and expenses involved against the cost
of the extra resource that the investor would need itself
to select and manage a portfolio.
- Consultants Consultants will offer similar
expertise to fund of fund managers, but may offer a
choice of discretionary or advisory services. The latter
will facilitate construction of a tailor-made portfolio,
as opposed to committing to a blind pool alongside other
investors. Consultants may also offer segregated rather
than pooled accounts. Consultancy services are also
offered by some fund of funds managers.
Private equity fund structures
An example of a simplified fund structure is provided
in the graphic below.
Legal and taxation aspects
Often it is necessary to create two or more vehicles,
with different structures or domiciles, to permit investors
in different countries to co-invest in a common portfolio.
Two of the principal considerations in any fund structure
- the structure should not prejudice the investor's tax
- investors should have the benefit of limited liability.
In relation to tax, it is important that there should
be no additional layer of tax at the level of the fund,
nor should investors be rendered liable to tax in another
country as a result of the fund's activities. As a result,
fund structures are often based on the principle of "transparency".
In other words, investors are treated as investing directly
in the underlying portfolio companies. A common structure
used internationally is the US or English limited partnership.
Although based on the principal of transparency, they
may not always be recognised as transparent in other jurisdictions.
Private equity investing is a long-term investment activity
and for this reason private equity managers generally
impose rigid restrictions on the transferability of interests
in their funds. Issues of liquidity can therefore put
some investors off. However, there are ways to circumvent
- Quoted private equity funds There are a number
of high-quality private equity funds in Europe that
are quoted on major European stock exchanges. Whilst
many of these were established to take advantage of
tax benefits, they remain less common than privately
held vehicles. Some of the reasons for this include:
- the tendency of quoted investment companies to trade
at a discount to asset value, which may fluctuate, eroding
the return on investment or making it more volatile;
- the limited ability to return cash to investors -
this means that when portfolio investments are realised,
the cash received remains inside the fund and dilutes
its performance until such time as it can be re-invested.
Still, some investors can for regulatory reasons only
invest in quoted securities and for these investors
quoted private equity funds remain a good option.
- Development of the secondary market There is
a rapidly developing market in interests in existing
private equity funds, referred to as "secondaries".
A secondary offering may comprise a single manager's
entire fund of direct investments or, more commonly,
a portfolio of interests in a number of different funds.
There is a growing number of well-financed investors
that specialize in purchasing interests in existing
funds from their original investors. Generally, however,
secondary purchasers do not offer a liquid or attractive
For the larger secondary portfolios, a buyer is commonly
secured through an auction process. For the smaller
transactions, these are often effected in a confidential
manner, sometimes with buyer and seller matched by the
fund's manager or by an intermediary. One of the keys
to a secondary transaction is securing the goodwill
of the underlying manager. The manager often has the
ability to refuse or restrict transfer of the interest.
In addition, valuation of the underlying assets is facilitated
by the co-operation of the manager. As institutional
private equity programs increase and start to reach
maturity, the ability for investors to realize some
existing commitments in order to raise cash for future
commitments will become more attractive. This will be
one of the factors that accelerates the development
of the secondaries market going forward.
Breaking new ground
- Structured products Specialist techniques of
structuring funds have more recently allowed private
equity fund products to be offered with features that
are attractive to particular types of investors. Through
securitization, incorporated fund vehicles are able
to offer interests to investors in the form of notes
or bonds with credit ratings, including convertible
securities. Such interests may also benefit from partial
or complete guarantees of the principal sum invested.
To date, such products have usually been funds of funds
structured as "evergreen" funds, meaning that
realized investment returns are not distributed to investors
but reinvested within the fund. Likewise, commitments
have generally been drawn down at the outset rather
than on a just-in-time basis for investment. These funds
are normally quoted.
- High Net Worth Investors Since it is not practical
for many to secure diversified exposure to a variety
of funds, bearing in mind the usual minimum commitment
size, there are a variety of pooled vehicle types that
may be offered. For example, dedicated feeder structures
may provide specific single-fund exposure to private
investors on a pooled basis. A variation of this model
is a pooled vehicle that provides exposure to several
pre-selected funds. Alternatively, investors can outsource
their investment decision-making by investing in a fund
of funds, such as a private bank.
Monitoring the Portfolio and Measuring
An active approach to monitoring the activities of a
fund holding can be a resource consuming exercise for
an investor. Larger investors may be offered a place on
the fund's Advisory Board, which generally focuses on
investor and conflict issues. Some investors will review
in detail the investment case for each of the fund's investments.
In some instances the opportunity to co-invest may be
available. Achieving a close working relationship with
the fund manager is a long-term objective, which will
promote a deeper understanding of the strengths and weaknesses
of the manager and investment strategy. Investors that
want to build a close relationship with their managers
should ensure that they are able to dedicate an appropriate
level of resource. For this reason, many investors will
limit the number of private equity fund manager relationships
that they maintain and to whom they commit funds.
- IRR and multiple Performance over time is typically
measured as internal rate of return and absolute gains
are measured as a multiple of the original cost. By
using both measures simultaneously it is possible to
illustrate the nature of returns. For example, a higher
multiple combined with a lower IRR would indicate that
the returns have been achieved over a longer period.
Conversely, a higher IRR over a shorter period may be
based on a small absolute gain. It is important for
investors to be aware that anomalous and unsustainable
IRRs are usually produced by uplifts in valuation that
occur early in a fund’s life. In addition, significant
realizations achieved early in a fund's life will have
a material impact on a fund's final IRR performance
even though its aggregate multiple may not be equally
impressive. Thus it is always preferable to look at
both measures in tandem.
The IRR is defined as the discount rate used to equate
the cash outflows associated with an investment and
each of the cash inflows from realizations, partial
realizations or its mark-to market (the expected value
of an investment at the end of a measurement period).
The IRR calculation covers only the time when the capital
is actually invested and is weighted by the amount invested
at each moment.
- Peer group benchmarking When comparing a fund's
performance with that of other private equity funds,
it is important to compare like with like. Comparing
two mid-market pan-European buyout funds against each
other would be appropriate. To compare sub-sector funds
established during the same vintage year is also appropriate.
As funds generally invest committed capital over a three-to-six
year period and generally harvest investments in years
three to ten, no meaning can be derived from comparing
a fund in its first year to a fund in its sixth year.
Also, funds with different vintage years may have experienced
different economic and investment environments, which
makes such comparisons inadvisable.
Whilst private equity funds do not usually publish their
return data, funds of funds and consultants maintain
their own databases of return information and should
be in a position to make comparisons. In addition, statistics
are publicly available showing aggregate quartile performance
by vintage year, geography and sector.
- Benchmarking against different classes of assets
The IRR computation is similar to that used to compute
the yield-to-maturity on a fixed income investment.
It is however different from the time weighted rate
of return calculation that is standard for mutual funds
and hedge funds as the variability of the timing and
amounts of private equity fund cash inflows and outflows
make it unsuitable. As a result, benchmarking against
other assets is not a straightforward process. One method
is to pick a benchmark index and to apply to a notional
holding of that index the same cash flows that are experienced
as a holder of an interest in the private equity fund.
For example, when the fund draws down cash, it is treated
as a purchase of the benchmark index of the same amount.
When cash is returned, again it is treated as a realization
of the same amount from the notional holding. If the
fund out-performs the index, then the notional holding
will have been reduced to nil before the fund finishes
distributing. Benchmarking a portfolio in aggregate
is also an option.
By European Private Equity and Venture Capiral Association,