Private Capital: An Investment Strategy for a Volatile Market
Amid uncertain equities markets, there is an investing strategy that makes some of the potential advantages of traditional private equity available to individual investors.
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Aug. 5, 2020 - Public markets have set records for volatility in the last year due to the pandemic,1 and many investors are wondering if they should diversify their portfolios. Traditional private equity (PE) is one possible option, but it often feels like an exclusive club that most people can’t join. Typically, only institutions and accredited investors, like high-net-worth individuals, can access the category. That’s understandable—traditional PE is a complex category, and it can entail some risks. But it has performed extremely well over the past three decades. These strong returns have attracted more capital. Prequin surveyed nearly 500 institutional investors at the end of 2020 and noted, “a majority of investors in private equity and venture capital (88%) stated performance either met or exceeded expectations.” Of those 88% investors, half plan to increase their long-term commitments in 2021.2
If your clients are individual investors, they may feel as if they’re missing out. And if they’re only investing in public companies, they are missing out. To help put this into perspective, as of the first half of 2021, there were 4,155 listed companies compared with more than 300,000 private companies.3,4 You can read more about it in previous blog post.
However, there are unique private equity strategies emerging that provide this access to everyday investors.
The Basics of Traditional Private Equity
Because traditional PE has been difficult for most individual investors to access, many aren’t up to speed on the basics of the asset class. (Why would they be?) But as new options emerge, it’s worth discussing how traditional PE works.
Big picture, private equity means that some of the owners of the company sell a portion or all of its equity to outside investors. Typically, those investors have bundled their positions together into a fund, which is run by a private equity firm.
The goal of most traditional PE firms is to buy companies, make changes to increase the value of those companies, and then sell them off in seven to ten years. Private equity strategies come in many forms, but broadly, there are three main types of strategies that are associated with traditional private equity:
- Venture Capital – Venture capital (VC) typically focuses on companies in the very early stages of their life cycles, or “start-ups,” with the hopes of long-term growth. Companies at this stage may have shown initial promise but may not be as established and are usually seeking substantial dollars for the first time. And, in many cases, they tend to have a narrower focus with portfolios concentrated in one industry, such as technology.
- Leveraged Buyouts – Leveraged buyout strategies (LBOs), which are really the most synonymous with the term PE, rely heavily on debt to acquire controlling stakes in a company. Typically, the ratio of an LBO purchase is 90% debt and 10% equity.5 While leverage can increase gains, it can also increase losses, particularly during a downturn. And many LBOs focus on turnarounds to reorient a struggling business.
- Growth Equity – Growth equity is typically viewed as a “bridge” fund between venture capital and leverage buyouts. It looks to acquire growth-stage businesses—with more historical financials than a VC, but less than LBOs. It will seek either a minority or majority ownership across a variety of industries and leverage amounts.
For individual investors, traditional private equity has downsides as well. Risk levels can be high, and funds often don’t start generating income or making distribution payments for several years after investors commit their funds, while it continues to raise capital and identify promising investments (a phenomenon known as the J-curve). And fees can be steep.
For individual investors, these risks are why traditional private equity is limited to accredited investors, who must meet certain criteria in terms of their income level, net worth, or financial expertise.
Private Capital
However, there is a unique strategy that offers some of the advantages of private equity but with some risk-mitigated features that make it available to everyday investors—private capital. Let’s look at how it works.
- Private capital includes both debt and equity, so it offers the potential for income and growth. (Traditional private equity, in contrast, doesn’t deliver returns until the portfolio companies are sold and the investors are paid off, and there’s no income component.)6
- Private capital focuses on established, high-quality companies that are growing, rather than trying to execute turnarounds on struggling firms. It seeks majority control (which means the fund’s managers can make the changes needed to improve performance) without taking on excessive leverage (so that companies aren’t burdened by excessive debt loads).7
- The companies’ management teams remain in place and have skin in the game, so their interests are aligned with those of the private capital managers.
- Finally, there are lower minimum investment amounts and greater transparency. To be clear, while private capital may be lower risk than traditional private equity, it is still considered higher risk than stock and bonds.
In sum, private capital is a different type of strategy—one that lets individual investors access the large and growing pool of private companies, and potentially capitalize on fast-growing businesses in that pool, while reducing some of the drawbacks from traditional private equity. At a time of serious uncertainty in the markets, it may be worth a conversation to see if it’s a fit for your clients’ financial needs.
There is no assurance these objectives will be met.
1 “CBOE Volatility Index (^VIX),” yahoo! Finance, accessed Aug. 19, 2021.
2 Preqin Investor Outlook: Alternative Assets, H1 2021. Results based on survey of 500 institutional investors, conducted in Nov. 2020.
3 “Listed Domestic Companies, Total,” The World Federation of Exchanges, 2020.
4 “Public, U.S. parent companies,” Dun & Bradstreet, data as of July 7, 2021.
5 Eric Reed, “Leveraged Buyout: Definition, Examples and Uses,” TheStreet.com, Jan. 14, 2019.
6 Distributions paid are not solely based upon performance. Distributions are not guaranteed in frequency or amount. Distributions will be paid from net investment income and, in addition, may be paid from offering proceeds, borrowings or reimbursable expense support, which will reduce future cash available for distributions and be dilutive to future shareholders.
7 Private Capital’s strategy is to use leverage in a small amount, for example it can be setup to not exceed 35% of its gross assets, subjecting it to inflation and interest rate risk. However, leverage may be used over the 35% limit at any time, if approved by a majority of the independent directors.
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