Three Reasons to Incorporate Private Equity In Your Portfolio Now

Three Reasons to Incorporate Private Equity In Your Portfolio Now

Peter Brunton, Chief Investment Officer

The term private equity sounds complex and something only utilized by the big institutions and the ultra-rich. And that is partially correct. In fact, the average institution invests 14% of their assets in private equity investments. (1)

However, private equity is not complex. It is simply investing in companies that are privately owned and not publicly traded on the stock market. The two most common forms of private equity investing are buyout and growth equity.

To break this down further, a buyout is where a private equity manager or fund takes a controlling interest in a mature company. Often, the purpose of this investment is to take an underperforming company and restructure the organization to make it more profitable. Once enhanced profitability has been achieved, the goal of the private equity firm is to sell the company (or pieces of the company) at a premium, or take the company public through an initial public offering (IPO). Some private equity firms use high forms of financing (debt) to accomplish these ends and enhance potential returns.

Growth equity is the other most common form of private equity and arguably has the highest upside. In this case, private equity managers invest in emerging companies that are showing substantial revenue growth but may not yet be profitable. These companies need the backing of a deep-pocket investor (the private equity fund) that has the resources, connections and operational expertise necessary to substantially improve profitability. The goal of the fund is for the companies to be acquired at a premium or become the next hot stock IPO.

Historically, these funds were only available to the ultra-rich and big institutions. Now, they’re accessible by individual accredited investors.

For accredited investors, below are three reasons you should be incorporating private equity into your portfolio right now.

Private equity provides exposure to the emerging technologies of the next decade:

The COVID-19 pandemic has transformed how we do business. E-commerce sales have grown six times the rate versus traditional retail. But, did you know that as of 2018, e-commerce has only represented 14% of total retail sales? (2) The ability for e-commerce to grow and increase market share is enormous.

Growth equity funds are hyper-focused on the trends and sectors like e-commerce that are expected to shape the next decade. Depending on the fund, these trends may include: cloud computing, web security, automation, medical technology such as tele-health, etc. All of which are considered instrumental technologies and platforms for the future of communication, workflow, and medical practice.

Private equity provides diversification benefits:

In 2008, there were 19,405 publicly traded companies in the U.S. and Europe versus only 10,035 private companies backed by private equity firms. In 2018, that reversed with 14,178 publicly traded companies versus 19,312 private equity backed. (3)

SEC reporting regulations have become increasingly burdensome. And many profitable companies do not want to deal with shareholder pressure. Gaining exposure to these highly profitable companies and sectors requires having an allocation to private equity.

Furthermore, private equity funds do not always take an equity stake. Often, they focus on directly originating loans to these companies. Big banks tend to shy away from these due to Dodd-Frank regulations, yet the directly originated loans offer high interest rates and strong collateral. Many times, the performance of these loans is independent of the stock market, which is necessary to truly diversify your portfolio. Some private equity funds even invest in infrastructure, which should benefit from additional stimulus efforts.

Private equity has historically provided superior risk-adjusted returns versus the stock market:

Performance of private equity has historically been predicated on two fundamental factors. One is an information gap. Publicly traded companies must disclose material facts and are covered by multiple analysts. That makes uncovering new opportunities more challenging.

In contrast, private companies do not have those reporting requirements and are not covered by mainstream media and analysts. Private equity funds have the connections to identify high-growth companies and the capital necessary to improve profitability.

The second fundamental factor is illiquidity. Often, private equity firms make an investment into a growth company and it takes three to ten years to ramp up profitability to the level where the company is an attractive acquisition or IPO candidate. That requires patience and not having shareholder pressure. The more illiquid an investment is, the higher the expected return should be.

Through 2019, the Cambridge Private Equity Benchmark delivered a 20-year annualized return of 11.2% versus 6.1% for the S&P 500. Furthermore, the worst quarter on the private equity benchmark was a negative 16.1% versus a negative 21.9% for the S&P 500. (4)

Through Dec. 15, 2020, the stock market has rebounded a whopping 67% from the March 23 lows caused by the COVID-19 recession. (5) Projected 2021 stock market valuations are now slightly below those seen during the tech bubble. While slightly above historical averages, private company valuations are less expensive, relatively speaking.

When you combine the tremendous growth potential of these emerging technologies, relative valuation versus the stock market and increased ability for accredited investors to gain access, now is the time to incorporate private equity into your portfolio.

For help deciding if private equity is the right move for you, please contact me.