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Private equity investing: is it worth a look?

Private equity investing: is it worth a look?

March 2024,  8 min read

 

Kristian Zimmermann, Co-Head of MLC Private Equity
Rachael Lockyer, Portfolio Manager MLC Private Equity


Private equity – investing in privately owned companies not listed on share markets – has enjoyed rapid expansion over the past few decades, especially among institutional investors, including superannuation funds.


But in a world of higher interest rates and inflation than has been the case for years, individual investors may be wondering if private equity (PE) investments may still be worth a look as one part of well-diversified portfolios.

We believe private equity offers the potential for strong returns over time – driven by specialist managers who can directly influence operational and financial improvements across investee companies. Like any potentially higher returning investment, it also has risks, which are discussed later in this commentary, and so investors should think carefully about whether private equity is right for them.

Australian Securities and Investment Commission (ASIC) data found that the most common asset class held by investors was Australian shares – with 73% investors owning local shares. The majority of investors (82%) hold five product types or fewer in their portfolios (local shares, international shares, even cryptocurrencies featured)1.

Private equity doesn’t feature in the top-five, but that’s not surprising because until recently it had been out of retail investors’ reach. However, that’s changing as the investment management industry has started to make private equity more accessible to retail investors.


Opportunities for growth

A reason PE managers can produce potentially strong returns is they take a hands-on approach.

PE managers are often specialists in the industries they invest in. They take an active role in the running of companies they own through choosing directors, shaping management appointments, and the development of business plans, which gives them greater ability to influence both the operations and the management of the business.

As specialists, PE managers can support and help these acquired businesses solve challenges and take advantage of opportunities in changing economic environments and help them to create value.

PE managers unlock this potential by working with the management of the companies they invest in to optimise operations, drive revenue growth, reduce costs, sell or turn-around less successful operations, and expand profitable activities through entering new markets, introducing new products, or acquiring other companies that provide access to new markets, technologies or customers.

The longer time horizon for PE investments, measured in years, often 4-5 years or even longer, instead of months, also enables these acquired companies to focus on structural changes and long-term initiatives that may not yield instant returns. This means they can take advantage of newly emerging technologies in areas like business digitisation, financial technology, and the growing use of artificial intelligence.

This is different to listed companies where management teams are under constant market and analyst scrutiny with respect to quarterly results, which may lead to a focus on short-term measures and not leave much space for long-term value creation initiatives.

The end goal for PE managers is to ensure the companies they invest in will enjoy a higher valuation at the time they come to sell their holdings. As PE managers share in the profits generated for investors after selling an investee company, they have a strong incentive to ensure these strategies really work.

PE as a portfolio diversifier

A well-structured private equity portfolio should be diversified across a large range of companies at various stages of their lifecycle, maturity, size, by industry, and countries.

The Australian share market is dominated by large, mature, financial and resources stocks, which arguably means that it’s not very diversified. In this context, investing in well-structured private equity funds may add to overall portfolio diversification.

Additionally, there are many more private companies than companies listed on stock exchanges, which means that investors limiting themselves to only investing in listed companies are effectively minimising the investment opportunity set.

In the United States, in 2020, there were an estimated 15,000 private companies with annual revenues over US$100 million versus 2,500 public companies with the same revenues2.

Furthermore, the number of publicly listed companies traded on US stock exchanges has fallen substantially from its peak in 1996 when the number exceeded 8,000 companies3. By 2020, the number had fallen by more than 50% to just 3,7004.

It is not that the United States has half as many companies as it did more than two decades ago – it is that companies are increasingly choosing to stay private for longer, or never list at all given the increased availability of private equity capital to support their growth5.

The same trend is evident in Australia too where a clutch of takeovers of ASX-listed companies along with a lack of new floats means the Australian share market has shrunk for the first time since 20056.
 

Retail PE funds

For individual investors, a way of accessing PE investments is via a highly diversified retail focused PE fund managed by an expert team.

Investing directly into a single institutional PE fund is not feasible for most people as minimum investments are usually very high (often several million dollars), top performing managers are difficult to identify and access, and there can be legal and tax complexities.

A well-constructed PE portfolio will be diversified across countries and regions, industries, PE managers, vintages (year of investment), and strategies (companies at earlier and later stages in their business cycles).

Investing in overseas markets – in particular North America, Europe, the UK, and Asia, which are much larger than the Australian market – gives PE investors access to a vast array of business opportunities that are unavailable in the local market.
 

Risks to be considered

Of course, any investment comes with risk. For PE investments, a major risk is the timescale for returns.

It can sometimes take several years for PE managers to identify appropriate investments, then formulate and execute on an investment thesis, before proceeding to sale (‘exit’) to generate potential profits. Until the successful selling of underlying investments, investors’ capital in PE funds doesn’t generate a cash return.

PE funds may invest in companies that are still at relatively early stages of development where the business model has not been fully tested, which involves higher risk than buying an established company on a public equity market.

PE managers will often use a substantial proportion of debt to finance their acquisitions, increasing their exposure to potentially higher interest rates, in the process. Unlike share market investments — whether directly held or via managed funds and Exchange Traded Funds — where investors can regularly buy or sell their holdings, investments in PE funds are typically ‘locked up’ for set periods to allow the manager time to work through their investment strategy.

Investors’ money can be locked in a PE fund for 5-10 years, so investors need to be comfortable with their money being inaccessible.

Another consideration is that PE funds may charge higher fees than some other types of investments where the fund managers are less actively involved in driving results.

Then there is operational risk, which is the risk of loss resulting from inadequate processes and systems supporting the private equity manager or the underlying companies in PE funds.

Unlike in public markets where prices fluctuate constantly, private equity investments are subject to infrequent valuations and are typically valued quarterly and with some element of subjectivity inherent in the assessment.

Finally, there are general market risks such as foreign exchange fluctuations, and changes in interest rates, just to name some.


Worth a look

In a challenging economic environment, it may be worthwhile looking at specialist managers who are actively improving the businesses they are investing in, while accessing broad diversification

 

References

1 ASIC Retail Investor Research Report, August 2022
https://asic.gov.au/regulatory-resources/find-a-document/reports/rep-735-retail-investor-research/
2 Power tool: Why private markets are no longer niche. Vic Leverett, 28 September 2021
https://russellinvestments.com/au/blog/power-tool-private-markets
3 America has lost half its public companies since the 1990s. Here’s why. Nicole Goodkind, 9 June, 2023, https://edition.cnn.com/2023/06/09/investing/premarket-stocks-trading/index.html
4 Ibid
5 Ibid
6 The ASX is shrinking for the first time in 19 years. Alex Gluyas and James Thomson, June 5, 2023,
https://www.afr.com/markets/equity-markets/the-asx-is-shrinking-for-the-first-time-in-18-years-20230601-p5dd33

 

Important information

This information has been prepared by MLC Asset Management Pty Limited (MLCAM) (ABN 44 106 427 472, AFSL 308953). MLCAM is part of the Insignia Financial Group of companies comprising Insignia Financial Ltd ABN 49 100 103 722 and its related bodies corporate. No member of the Insignia Financial Group guarantees or otherwise accepts any liability in respect of the Fund or the services provided by MLCI. The information contained in this communication is general in nature and does not take into account your objectives, financial situation or needs. Because of that, before acting on this information we recommend you obtain financial advice tailored to your own personal circumstances.

The information in this communication is prepared for information purposes only and does not purport to contain all matters relevant to any particular investment. Any opinions expressed in this communication constitute our judgement at the time of issue. We believe that the information contained in this communication is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, no warranty is made as to their accuracy or reliability.