Private equity (“PE”) has now established itself as an asset class and has become an increasingly central part of the asset allocation of both institutional and private investors. The system comes with a number of benefits. In this post, we aim to address the key factors behind private equity outperformance, provide an overview of the returns that can be expected from a diversified private equity portfolio, and propose a framework for portfolio construction in light of planetary boundaries.
Investing in private equity is like investing in the real economy because it directs capital into companies and into their founders. The core of the private equity investment model is the relationship between a fund manager as a “principal” and a business manager as an “agent”. We believe that private equity, for various reasons, is characterized by a better reconciliation of the interests of the individual stakeholder groups. As majority owners or significant minority owners of companies, private equity investors are usually directly involved in the design of the companies and their management teams and support their activities with additional strategic and operational advice. This is only possible through complete control over or significant influence over a company’s board of directors. Examples include the ability to quickly replace or increase underperforming management teams, the ability to appoint board members who typically have relevant industry experience and networks to add value, and the freedom not to deal with disruption from minority shareholders or to deal with pressure from activist investors. Private companies owned by professional private investors are also immune to the overly stringent regulatory requirements in public markets, which are primarily designed to protect retail investors.
Private equity fund managers are also able to achieve significant synergies across their portfolios, and an increasing number of fund managers specialize in specific sectors where they have accumulated the greatest expertise.
Another driving force behind the better reconciliation of interests is the longer investment horizon of private equity investors. Private investors, especially venture capital fund managers, can support loss-making companies for a number of years, allowing them to focus on product and service development, leading to higher levels of innovation. Companies owned by private equity investors may take longer to execute their strategic moves because they do not face the same pressure from stakeholders to meet and exceed quarterly earnings forecasts.
In addition, private equity’s specific incentive mechanisms also provide an additional driving force for outperformance relative to listed equities. Fund managers and management teams in their portfolio companies are primarily compensated by the occurrence of a successful liquidity event, ie. when a portfolio company is divested or listed. A liquidity event typically precedes a comprehensive due diligence on the part of the buyer and a competitive auction process that provides some assurance of the fundamental value of the business being transferred. This type of performance fee (or “carried interest”) ensures that long-term fundamental value creation is rewarded. It can also be assumed that private equity incentive mechanisms attract more talented management teams. Managers and founders of companies owned by private equity investors typically receive a share of the proceeds from a successful sale, often in the form of large share blocks.
Do private equity firms outperform comparable listed companies?
Most alternative asset classes require specific tools to measure performance. Private equity is no exception; the three performance indicators below are the most commonly used. Total Value to Paid-In (TVPI) is the sum of distributions received and the residual value of an investment divided by the invested capital. The ratio to paid-in (DPI) measures the “level of realization” of an investment by comparing distributions in relation to invested capital. The DPI ratio indicates how far below or above the return (DPI = 1.0x) a particular private equity investment is currently. Finally, as a money-weighted performance measurement, the internal rate of return (IRR) is best suited for private equity investments, as the timing and size of cash flows must be taken into account when assessing a fund manager’s performance.