Private equity investing: is it worth a look?

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.  

However, it is underpenetrated as an asset class for retail investors. By contrast, institutional investors, including sovereign wealth funds, have historically invested between 5-20% of their portfolio in private equity, with Australia’s Future Fund holding 15% of its portfolio in the asset class.¹

For the general investment public, the case is quite different. The Australian Securities and Investment Commission found that the most common asset class held by investors was Australian shares – with 73% of 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).²

Private equity doesn’t feature in the top-five product classes held by Australian retail investors, but that’s not surprising because until recently it had been out of retail investors’ reach.

Historically private equity funds have required commitments in the millions of dollars or tens of millions of dollars, to access their funds. Some funds remain shut to new investors and are instead offered only to long-standing supporters who are large institutions. But 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 strong returns is they take a hands-on approach to creating value in the companies they invest in.

PE managers generally take an active role in the running of companies they own through choosing management, working to improve corporate governance, and developing business plans based on detailed due diligence and insight gives them a strong ability to influence the operations of the business.

PE managers are often specialists in the industries they invest in and this enables them to support and help these acquired businesses solve challenges and take advantage of opportunities in changing economic environments and create value.

PE managers aim to 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.

They heavily incentivise management to achieve their growth plans and typically have strong alignment with those working day-to-day running the business.

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.

In listed market, managers are penalised for not meeting annual targets. In the private equity environment, private equity managers and management teams work collaboratively to improve businesses with a long-term outcome (that is, an exit (sale) of the investment) in mind.

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 and are implemented effectively.

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 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 reducing 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, six times more than the 2,500 companies with the same revenues listed on public markets.³

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 companies.⁴ By 2020, the number had fallen by more than 50% to just 3,700.⁵

It’s 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 growth.⁶

The same trend is evident in Australia too where a clutch of takeovers of ASX-listed companies along with a lack of new floats saw the Australian share market shrink in 2023 for the first time since 2005.⁷

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.

Of course, any investment comes with risk. For PE investments, a key risk is the timescale for returns. As mentioned earlier, a typical PE investment might take 4-5 years or even longer to be sold, and investors typically demand a premium to compensate for this. 

Worth a look

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