Private equity & venture capital

Private equity has been a form of investment for more than a century. Born out of the industrial revolution, private investments emerged as wealthy families contributed funds to building transportation. Over time, the asset class has expanded to encompass a vast array of investment types, now with trillions of dollars-worth of assets under management. In this lesson, we'll explore what constitutes a private investment, the story of its inception, strategies, and why investors choose to allocate funds to this sector.

What is private equity?

Private equity is an asset class in which capital is invested in private companies in exchange for equity or ownership. Private companies are not publicly traded or listed on a stock exchange. Public companies can also be acquired by a private investor – in these circumstances, the public company becomes private and is de-listed. The industry currently has a total AUM of $4.11tn. In 2019, the average value of a buyout deal was $487mn.

Private equity capital comes primarily from institutional and accredited investors that either invest directly in companies, or through funds managed by fund managers. In comparison to public equity investments, which trade daily, these are long-term and illiquid. Some of the most active investors are private equity fund of funds managers, pension funds, endowment plans, and family offices.

Definitions of private equity differ. In its broadest sense, the term can include niche strategies such as venture capital, real estate, infrastructure, and debt transactions - this is what we would refer to as 'private capital.' For the purposes of this lesson, private equity specifically refers to investments made in companies, as opposed to hard assets such as real estate or infrastructure.

The history of private equity

In this lesson, we dive deeper into the history of the asset class from its beginnings to the modern day.

Today the term private equity is very different to what it was 20 years ago. The traditional pooled fund structure is still widely used and accounts for most of the capital at work in the industry, but managers have evolved their offerings to cater to the changing needs of investors. Many investors are utilizing alternative methods of accessing the asset class such as direct investments, co-investments, and separately managed accounts. Meanwhile, some managers are moving away from the traditional commingled fund to more customized offerings and branching into new asset classes and strategies, such as private debt.

Private equity vs. venture capital

As already outlined, ‘private equity’ as a generic asset class term encompasses a multitude of different investment strategies, including venture capital. However, when used at the investment level there are key differences between private equity and venture capital investments; foremost of which is the maturity of the portfolio companies invested in. Venture capital investments are characterized by providing capital to young, start-up, or early stage businesses that are or have the potential to grow quickly.

VC investments are characterized by iterative rounds of financing with additional capital provided as growth/return on investment is achieved. Private equity investments are typically in larger, more mature businesses with proven financial record. Further differentiating traits include:

• Risk – VC investments are higher risk than PE, due to the unproven nature of the businesses invested in.
• Ownership stake – VC firms typically acquire minority stakes whereas PE firms acquire controlling stakes.
• Structure – VC firms normally make pure equity investments whereas PE firms use equity and debt.
• Investment amount – PE investments are typically larger than VC investments as they acquire greater ownership stakes and are in more mature businesses.
• Value creation – VC investments rely on company growth and valuation of the business increasing, whereas PE investments rely on both growth and financial engineering including multiple expansion, debt settlement, cash generation, and so on.

As the industry has grown and firms have broadened their offerings for investors, lines have blurred. Some VC firms have moved into expansion and growth areas, and some firms also provide debt financing (venture debt) to pre-revenue companies. Some traditional PE firms are also moving down the chain, raising dedicated funds focused on early-stage start-up investments.

Private equity investment strategies

There are six key strategies and fund types for private equity investments – buyout, venture capital, growth capital, turnaround, fund of funds, and secondaries. Explore the below for an overview of each strategy.

Buyout

In a buyout investment, the investor often has complete or majority ownership and control of the company. Frequently, investors ‘shake up’ or replace the management teams and are relatively involved in operational decision-making. Buyout represents the largest strategy segment within private equity as measured by assets under management, and as such has an impact on the aggregated performance of private equity as an asset class.

The investor controls investments in the equities of mature private companies using a combination of equity and debt. Debt is utilized as it has a lower cost of capital than equity since interest payments reduce corporate tax liability, unlike dividend payments.

Venture capital

Investments made in start-up companies and early stage businesses that are believed to have significant growth potential. There are different stages of venture capital financing across angel, seed, late stage and expansion, which are reflective of a company’s maturity level. As a company grows, additional financing is provided in the form of ‘rounds’ to facilitate further development.

Growth capital

Growth capital can be seen as part of the venture capital strategy or its own strategy. For this type of strategy, investors take a minority or non-controlling stake in companies they believe will grow. In most circumstances, the investor has a passive approach and retains the same management team to oversee operations. The companies invested in are often relatively mature compared to venture capital, but less mature than the companies targeted in buyouts. The focus is more on market expansion as opposed to cost cutting or financial engineering. Typically, lower levels of leverage are used in growth capital than for buyout transactions.

Turnaround

This strategy targets companies with poor performance, or those experiencing trading difficulties. The basic concept is to buy cheap and sell high, with the difference between the depressed price at purchase and improvements at the time of sale creating a return on investment.

Private equity fund of funds

Funds of funds are vehicles raised by managers with a mandate to invest in the funds of other managers. The key value add for the investor is that they need only conduct a diligence process around the manager they have invested with. The fund manager will then proceed to source potential investments, carry out due diligence, and monitor the other managers holding the investors' capital.

However, there are higher fees and a smaller portion of profits go to the allocator, with less control over the underlying managers selected. This is a good option for allocators with small or inexperienced investment teams who would not be able to carry out the allocation process in-house.

Secondary fund of funds

This is a specialized fund type that looks to purchase other investors’ stakes in private equity funds. These funds will capture a portion of the anticipated growth in value of an investor's fund stake. Depending on when the fund stake is sold, the buyer may not obtain the full value of growth, as a percentage will have already gone to the original investor.

Private equity risk and return

While private equity has often delivered returns at the higher end of the private capital spectrum, it is also one of the riskiest private capital strategies, primarily due to the nature of the assets. The equities of private companies often derive their value from intangibles like brand, customer base, patents, and distribution channels, which are harder to liquidate in times of difficulty than physical assets such as real estate, gold, or oil. These physical assets are tangible, easier to value, and usually hold at least residual value in times of crisis, making them less risky.

Private market performance can be analyzed in several ways. This includes making comparisons against the public markets, capturing average returns earned by LP portfolios based on the amounts invested, or analyzing fund internal rate of return (IRR).

Private equity: risk/return by fund type (vintage 2011-2017)*

Explore below the risk/return profiles of private equity strategies.

Buyout

Buyout is the largest strategy segment within private equity as measured by assets under management. Therefore, it has a significant impact on the aggregated performance of the entire asset class. Buyout funds have generated strong and steady returns in recent years, driving much of the cash distribution seen in the private equity industry and contributing to investors’ positive view of the asset class. Smaller buyout funds often post the highest returns, as at purchase they are lower in price and worth significantly more by time of sale. Larger buyout transactions also present opportunities for strong returns, as companies restructure with the aim of improving operations and finances.

Venture capital

Venture capital has one of the highest potential rates of return, particularly for early stage investments. However, the success rate of early-stage companies is highly variable, with some experiencing phenomenal growth and others failing altogether. This creates a wide variation in outcomes for investors in the strategy: less than 20% of venture capital investments deliver positive returns. Later-stage venture capital investments carry lower risk as they are further along in their development, but this makes the potential returns lower too.

Growth capital and turnaround

Growth capital and turnaround investments also carry a reasonable amount of risk as they rely on growth or improvements in company performance actually being achieved. The returns for growth investments are not as high as buyout transactions due to the non-controlling stakes often taken, whereas in turnaround investments investors tend to buy low and sell high, therefore reaping higher returns.

Fund of funds and secondaries

Investments in fund of funds and secondaries tend to carry the lowest risk. In secondaries funds, risk is minimized as investors already have an indication of performance. In funds of funds, this is because investments are diversified across multiple funds. However, the double layer of fees puts funds of funds at the lower end of the return spectrum.

Why invest in private equity?

Private equity is a well-established part of many institutional investor portfolios, as it generates higher absolute returns while also improving portfolio diversification.

1. High absolute returns

In order to achieve high returns, private equity investors aim to buy low and sell high. Once a business has been acquired, improvements can be made to increase its value prior to exit. Private companies tend to be smaller and cheaper to buy since they are not easily sold or valued – hence the greater absolute return.

As in public equities, investors in private equity are subject to market risk, credit risk, and operational risk, but they also carry additional risks due to the illiquidity of underlying assets. The limited regulatory oversight of management and reporting conventions is seen as another investment risk within private equity. As a result, investors expect a higher return for their private equity investments relative to those in stocks or bonds.

2. Diversification

Private equity offers portfolio diversification benefits for investors in two key ways:

• Low correlation to public markets, such as traditional investments in stocks and bonds. Exposure to private, unlisted companies provides investors with uncorrelated returns and a greater degree of diversification within their portfolio.
• Another benefit is that investors are allocating to funds which invest in a variety of companies. Therefore, investors have access through these funds to not only different industry sectors within private equity, but different geographies as well.

3. High risk-adjusted returns

Risk-adjusted returns are measured by comparing the level of risk involved in the investment and its subsequent return. An investor analyzes financial, credit, market, and operational risks to generate the potential risk factor. Often, the returns within this asset class, while risk-adjusted, are higher than for traditional investments.

In this lesson, we revealed more about the private equity asset class. From its history to the investment strategies available and the risk/return profile, you now know the reasons why investors choose to allocate funds to private equity.