Private equity
What is private equity?
‘Private equity’ means an equity investment in any commercial enterprise that is not registered for public sale. It includes:
- start-ups where companies are at the concept stage or shortly after the company’s establishment;
- early stage investment for companies just out of the ‘start-up’ stage;
- development capital for established companies to fund acquisitions or other capital projects;
- management buy-out or buy-ins where public companies are taken private by an internal or external management team; and
- ‘special situations’ which generally involve rescue packages i.e. restructuring capital for companies that are in financial difficulties.
The first two are collectively known as ‘venture capital’.
Exposure to private equity could be made either through direct participation in privately placed offerings or through investment in one or more pooled investment vehicles that, in turn, invest in private equity.
Advantages of private equity
- Higher expected return
The expected return from investing in private equity will be higher than that for quoted equity. The difference, a ‘risk premium’, compensates investors for the greater risk e.g. investment in more highly geared companies and work required to invest in private equity as well as the reduced liquidity. We believe that the extent of this premium is sometimes exaggerated through the selective use of data, often of dubious quality.
- Diversification
It is difficult to get sufficient data to analyse the inter-relationship between private equity and other asset classes. However, it is likely that private equity would offer some diversification within an equity portfolio. In the recent past, many private equity funds produced positive returns when the publicly quoted equity markets were suffering dramatic losses.
The disadvantages of investing in private equity
- Increased volatility
Private equity will generally be more volatile than publicly listed securities. The risk of a total collapse of an investment is more significant.
- Expense and time
The management charges associated with private equity are much higher than for quoted equity management (in the order of 2-3% pa). The work involved in selecting and monitoring private equity investments is greater than for quoted equity investments. Even investment returns need to be calculated on a different basis. Because the manager can manipulate the valuation of his holdings, the time-weighted rate of return (used for most other investments) is not appropriate.
- Increased uncertainty / lack of data
Due to the nature of private equity, there is little publicly available pricing information on individual holdings, sectors or the asset class as a whole. This makes decision making more difficult.
- Illiquidity
Generally, investments in private equity are tied up for a set period. This is not normally a major concern for pension schemes unless a very significant proportion of the assets are invested in illiquid investments. The lack of liquidity becomes more of an issue in difficult market conditions e.g. the recent financial crisis.
- Reputational risk
If the returns are very poor (which could happen regardless of which assets a scheme invests in), more exotic investments could lead to the trustees facing increased scrutiny.
Conclusion
We believe that private equity is a good asset for large pension schemes to consider. However, for small schemes we believe that the potential benefits of private equity investment would be eroded through the additional time and cost spent in setting up and monitoring the investments. Alternative methods of increasing expected investment returns (such as switching gilts into corporate bonds) are available and should be considered.