Why private equity can be a good addition to your portfolio

What is private equity?

Private equity, commonly known as PE, refers to shares or ownership in any company that is not publicly traded on a stock exchange. It tends to be illiquid and is thus suitable for a longer-term investment horizon. In contrast, public equity investments can be traded daily.

Private equity is today a trillion-dollar investment class that comes under alternative investments (or alts, for short). Other alternative asset types include real estate, private debt, infrastructure, and commodities.

PE investments are often in bigger and more mature companies with a proven financial record, unlike venture capital (VC) investments, which typically go to young or early-stage businesses with the potential for fast growth. That being said, the lines between PE and VC are blurring, as many firms in both spaces have broadened their offerings for investors.

How does private equity investing work?

Most of the PE capital comes from professional investors and institutional investors, such as family offices and pension funds. Investors can access the asset class in several ways, including investing directly in the private company, or through funds, co-investments, or separately managed accounts.

The pooled fund structure, in particular, is widely used. A private equity fund is known as a limited partnership, and investors who contribute to it are the limited partners (LPs). Investment professionals from the PE firm that created the fund are the general partners (GPs), and they will manage the investments.

After forming the fund, the firm puts out a call for investors to pool their money, which will be used to invest in private companies according to a specific investment strategy and approach.

Usually, the goal of a PE fund is to sell its stakes in the portfolio companies for a high return on equity at an opportune time. There are different investment strategies a fund can adopt to attain this goal, and every fund will have a particular return target.

Under a buyout strategy, the fund takes a controlling interest and finds ways to build value, such as by organically expanding its business or improving an underperforming unit. In buyouts, PE investors will be focused on the product, business plan, and quality of the target company’s management — they may even recruit a new management team to run it.

In 2021, buyout deal value and exits both hit eye-watering record highs. Analysis from Bain & Company showed that the US$1.1 trillion in buyouts doubled 2020’s total of US$577 billion and broke the previous record of US$804 billion — that was first set in 2006 during the heady times leading up to the Global Financial Crisis.

If the fund takes a turnaround strategy, it buys shares in a struggling company for cheap, fixes it up, cuts costs, and rejigs operations, before selling at a higher price when the company is out of the woods.

PE investors often aim to add value to the target company, to maximise profits when their shares are sold. 

Plans for any value-creation initiatives should be carefully laid out and reviewed before making the investment. Examples of such initiatives range from technological upgrades and corporate reorganisations, to cost-cutting exercises and the introduction of environmental, social, and governance (ESG) frameworks.

Why invest in private equity?

Investors looking for higher returns and further diversification can consider adding private equity to their portfolios.

PE has the potential to increase the overall portfolio return. Private equity funds tend to offer more attractive returns, when compared to traditional assets like public equity and even other alternatives. 

Moreover, private equity helps to diversify your portfolio by mitigating both public market risk and cyclical risk. Diversification is best achieved when the investment portfolio is built with assets that are not perfectly correlated.

PE funds’ returns have a low correlation with public markets. Although broader economic conditions might have an impact on each portfolio company’s performance at a fundamental level, PE fund managers work to create value over the long run, seek out long-term returns, and thus are unlikely to jump in and out of investments on a whim. 

That stands in contrast with the public markets, which are highly liquid and may see many investors speculating and trying to time the market by trading frequently.

Also, private equity funds usually invest in a variety of companies, giving the LPs access to different sectors and geographies.

Data shows that in times of stress or public equity underperformance, investors allocate even more to private markets.

Private equity in a downturn: resilient and diversified

Historically, private equity has outperformed public equity throughout the boom and bust market cycles. A report by Neuberger Berman that analysed the major economic downturn of the early 2000s, the 2007-2009 global financial crisis, and the 2020 Covid-related market events, found that private equity historically experienced a less significant drawdown and a quicker recovery than public equities in all such instances.

The resilience reflected both the greater insulation from public market sentiment and the amount of active control that private equity investors have over portfolio companies, the Neuberger Berman report noted. Private equity firms have room to enhance value returns during challenging times. (Note that given that PE funds are run by active managers, fees tend to be higher than those for a managed portfolio of public equity.)

Private equity proved particularly resilient during the Global Financial Crisis, noted by some as the first real test for the investment class. Data from Preqin shows that the S&P 500 was hit by a maximum drawdown of some 40% between 2008 and 2009. Private equity, however, as measured by the Preqin Private Equity Quarterly Index (PrEQIn) was down by just 26.6%.

To be sure, Preqin points out that the circumstances of the market today reflect different pressures, specifically with inflation and rising rates — this is an unprecedented test for the asset class.

Observers are clear about the pressures that inflation and rising rates will bring to the PE market, but this is also why the broader industry shift into specialisation is key. Investors will have to seek out curated offerings from platforms such as Endowus to match them to their needs.

How to build a diversified portfolio with private equity

Many individuals stick with the public markets and maintain the classic 60/40 mix of assets (60% stocks and 40% bonds). This portfolio construction is guided by the idea that equities and fixed income usually don’t move in tandem, therefore when stocks perform poorly, bonds may offset some of the losses and provide income.

However, the turbulent and uncertain markets in 2022 thus far have shown that traditional fixed income may not always serve as a shock absorber in a portfolio, and both stocks and bonds have been moving downwards in recent months.

With this in mind, investors may wish to introduce private equity to diversify the stocks component of their portfolio, be it within a 60/40 mix or another asset allocation strategy, to ride out the volatility and benefit from the liquidity premium. 

‍Bain & Company points out that with the PE industry maturing, private equity investors are also seeking out fund specialisations that will provide diversification benefits. While fintech and healthtech are new themes that have dominated in recent times, other sub-asset classes such as growth equity, infrastructure, and secondaries are emerging. 

Before investing in PE, consider if you are comfortable with the investment strategy and whether it fits your objectives. This will determine whether you commit capital in a buyout fund that aims to add value to a mature company, versus a growth equity fund that looks for rapid growth and may take on minority stakes, for instance. 

Investors can also choose funds with a specific sector or geographical focus that differs from their existing allocations, to diversify their current portfolios.

2021: a record year for private equity fundraising

For a sense of scale, 2021 was a blockbuster year for private equity players. A record of nearly US$1.2 trillion in funds was raised from a year ago, up by close to 20 per cent from 2020. Assets under management surged to an all-time high of US$9.8 trillion as of July 2021.

Analysis from Bain & Company further showed that average deal size blew up to US$1 billion for the first time ever, helped by cheap debt and record levels of dry powder. Dry powder here refers simply to capital found in buyout funds that has not been deployed. As of 2021, that global dry powder stood at a record US$3.4 trillion.

What are the risks involved in private equity?

Private equity carries additional risks due to the illiquidity of the underlying assets. Funds impose a lock-up period for the LPs’ stakes, during which the GP can use the capital for the value-creation initiatives at the portfolio companies. Investors will not be able to liquidate their positions for a number of years.

The nature of the assets also makes PE one of the riskier private capital strategies. The value of private companies’ shares typically hinge on intangibles such as their customer base, patents, and brand — which are more difficult to value and tougher to liquidate in times of crisis, than physical assets such as gold or real estate.

In private markets, there is limited regulatory oversight and companies do not need to follow strict reporting requirements, unlike public companies. Due diligence is therefore crucial to evaluate all investment opportunities, minimise risks, decide which deals are worth pursuing, and set a suitable purchase price. Many PE firms have substantial research and due diligence teams to assess the financial, legal, and management situations at prospective target companies.

Debt is often used to finance PE investments. This allows a fund to put down smaller sums of cash and get greater gains if it sells at a profit. To be sure, it also means the risk of loss is significant if the investment fails.

In general, alternative investments are complex and suitable only for investors with sufficient knowledge and experience to understand the risks involved.

The alternative funds that will be available on the Endowus Fund Smart platform will only be accessiblea by professional investors, at an institutional low-cost fee. There is a minimum investment but as with all our offerings, we do not charge sales or redemption fees.

Start your private equity investing journey with Endowus Private Wealth

Alternative investments such as private equity, real estate, and commodities can help enhance traditional portfolios.

Private equity can play an important role in a long-term, diversified, multi-asset portfolio for disciplined investors, although there is no single recommended allocation for everyone.

Investors should give careful consideration to their overall portfolio strategy — including their risk tolerance, cash flow needs, and liquidity constraints — before adding any new assets to their portfolios. Remember that any shift in the balance of assets can change the overall portfolio return and risk.

Endowus has a private wealth arm that provides access to more investment products such as alternative investments. With Endowus Private Wealth (EPW), clients looking to invest a minimum of US$1 million in assets across our services can gain exclusive access to more personalised solutions and products.

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