Private Equity...explained

Private equity?

Private equity investment has been gathering momentum recently. However, many remain wary in investing, not fully understanding what it involves and harbouring concerns about issues including risk, volatility and illiquidity.
In the first article in a series in the subject we will be looking at what private equity is.

What is private equity?

Equity is investment in private, or unquoted, companies. It comprises two main areas:

• Venture capital – the provision of finance to start- up companies;
• Buyout – purchase of established businesses with mature cashflows.

How does private equity investment work?

Private equity managers create funds to raise capital. They seek out investment opportunities and undertake due diligence to assess companies’ potential.  Once a suitable company has been identified the manager draws down some of the investors’ pledged capital, or commitment.  After investing the manager takes measures to add value.  This is s slow process typically taking three to five years.  At the end of this period the investment is exited through an IPO, trade sale, management buyout, merger or recapitalisation. The realised funds are returned to the investor.  This process continues through the life of the fund.

Benefits of private equity investing

Return potential:  Most private equity investment occurs, in the US, and it is thus the best source of performance data.  The 10- year average US private equity return to December 2006 was 16%pa, outperforming the S&P500 by 8%pa. however, there is large divergence between the average manager and the top quartile managers.  Investing in top quartile managers only would nave added an extra 10-15% pa.
Portfolio diversification: Within a balanced portfolio, the introduction of private equity can improve diversification.
Alignment of interests:  compensation strategies are designed to align the interests of management and owner.
Leverage:  The company’s funding is reorganised in an efficient manner, lowering the cost of capital.
Long – term strategies:  Private companies are not subject to quarterly shareholder scrutiny so have more freedom to pursue long – term strategies even if it impacts short – term returns.

Challenges of private equity investing

• Long – term investment and liquidity: Typical private equity funds have a life of 10-12 years.  They are normally closed – end structures, meaning the investor has limited or no ability to disinvest during the find’s life. Private equity is only suitable for investors with long(>10years) time horizons.
• Resource requirement: Investing directly in private equity funds requires a great deal of skill and time to carry out the necessary due diligence.
• J- curve effect: This refers t the exposed poor returns in the years.  Management fees and expenses are payable from the start, but it takes a number of years for returns to start feeding through.

Ashlin Noonan, F.I.A
Head of Asset Liability Modelling and Strategy Formulation
Novare Actuaries and Consultants