As astronaut Neil Armstrong once said, “Mystery creates wonder and wonder is the basis of people’s desire to understand.”
Although we won’t be talking about space in this paper, we will discuss an asset class that remains a mystery to many investors. A better understanding of private investments, specifically private equity in this case, will broaden the opportunity set to those looking beyond traditional stocks and bonds.
At a time when expected returns for traditional, publicly traded stocks and bonds are below historical averages (look no further than the 10-year Treasury note yielding 0.70%), we believe considering the utility of private equity is logical. With appropriate analysis and due diligence, we think such investment options have the potential to add incremental return and additional diversification to a thoughtfully constructed portfolio. Although not appropriate for everyone, a clear understanding of what private equity is (and what it isn’t) will facilitate a more thoughtful and educated decision-making process. We also believe that shifting public market dynamics and the dislocation created by COVID-19 makes the discussion particularly timely.
Private equity is a type of “alternative” investment, a blanket term often used to describe the vast array of investment options that do not fit neatly into one of the conventional equity, fixed income, or cash asset classes widely used by investors. Examples of alternatives include, but are not limited to, the following: private investments (equity, debt, real estate/infrastructure), hedge funds (long/short equity or fixed income, arbitrage – convertible/merger, macro, event-driven, managed futures, market neutral), commodities (industrials, precious metals), and collectibles (fine art, coins, stamps, etc.).
Investment firms specializing in private equity are also called general partners (GPs). GPs are tasked with raising pools of capital (“funds”) from investors and then subsequently investing that capital in private companies at various stages of development. Investors that allocate capital to private equity funds are considered limited partners (LPs), which generally consist of institutional investors and individuals that meet accredited investor standards. LPs abdicate operational oversight of the respective portfolio of private companies to the GPs, who will often become actively involved with the portfolio companies in which they invest to unlock additional value for the business and its investors.
There are several different styles of private equity investing. Often, it is the portfolio companies’ stage of development that determines these labels. For example, Venture Capital/Angel investing focuses on start-ups/early-stage businesses that are unprofitable and have very little, if any, revenue. Businesses seeking this type of funding are only willing to relinquish a minority equity ownership stake. The allure of finding the next cutting-edge technology or rapidly growing franchise is attractive to certain investors. GPs that specialize in Venture Capital invest in many deals, with the realization that a large percentage will likely fail. This category has the greatest level of dispersion in terms of manager performance and has the highest overall volatility. These investments typically require very high minimums to access to best GPs.
Growth Equity is the next phase within the business life cycle. Companies at this stage of development are often not cash flow positive but have started to produce goods/services and need capital to ramp up growth. Like Venture Capital, these businesses are typically not willing to surrender control to an outside entity but have a more well-defined business model with lower failure rates.
Buyouts, which follow Growth Equity in the business life cycle continuum, are the largest strategy group and account for most of the private equity funds raising globally. In North America, private equity firms within the Buyout category raised nearly $250 billion in assets in 2019, by far the highest level relative to other categories within private equity. Deal sizes can range from less than $25 million to values that are well into the billions. Private equity firms within this category take a majority ownership stake and play a more active role in managing operations.
Distressed/Special Situations private equity is the fourth category. As the name implies, companies that fit this profile are mature, in a state of decline, or have encountered short-term operational issues. This category is also a “catch-all” for private investments that don’t neatly fit into one of the groups referenced above.
When general partners take an ownership stake in a company, they typically purchase most, and in some cases, all the outstanding equity. General partners are actively involved in running the day-to-day operations – a scenario not commonly found in professional investment firms managing publicly traded equity portfolios. They will also have a longer time horizon than the typical stock market investor and have a clearly defined exit strategy for each investment that is made. Skilled managers within the Buyout cohort can augment future value by making management changes, controlling costs, improving operational efficiencies, or identifying new customers in an effort to grow revenues. There are many innovative founders of companies that possess considerable technical expertise but often aren’t as adept at running day-to-day operations. The willingness to make decisions that are in best interest of shareholders for the long-term, as opposed to managing to quarterly earnings reports, is a key reason why alpha can be derived by a skilled private equity manager. Based on the data we’ve reviewed, the cons associated with illiquidity and less transparency can be more than offset by the positive return differential (300-500 basis points – 3% to 5% per year) that investors in private equity have historically been able to earn over public equities.
We mentioned earlier that there is wide disparity in the returns generated by Venture Capital firms. While the level of performance variation is not as extreme within the Buyout category, there is still a considerable return spread between top quartile and average performers (see Exhibit 1). In addition, based on Bain Capital’s analysis, the returns for the average Buyout private equity fund have fallen, while top-quartile returns have remained consistent.
In order to give us the greatest chance of identifying the best GPs, BMT will be partnering with Capital Dynamics, which has more than three decades of experience analyzing private equity organizations and has access to top tier GPs with specialization across various industries, geographies, and deal structures. Capital Dynamics typically focuses on middle market deal sizes, targeting businesses with enterprise values (Equity+Debt-Cash) between $100 and $500 million. According to Capital Dynamics, this segment of the private equity market offers opportunities for significant value improvements, an abundance of potential investments, more attractive entry multiples, and the possibility of multiple expansion when the investment is exited.
Exhibit 1: Global Buyout Rolling 10-Year returns: 30 Years Ending 12/31/19
Changing Market Structure
In a world of suppressed interest rates and moderate economic growth, investors have been willing to pay top dollar for public companies that are able to demonstrate strong and consistent growth characteristics. As gross domestic product (GDP) expansion has slowed in recent decades throughout much of the developed world, investors have piled into stocks like Microsoft, Amazon, and Apple, desperately searching for above-average growth. As a result, these three stocks now account for about 18% of the S&P 500, carrying an average price-to-earnings ratio of over 45 (compared to 22 for the overall S&P 500).
Investing in high growth companies via public markets has become more expensive as the opportunity set has become smaller. For example, in Exhibit 2, we see fewer technology IPOs, and the IPOs that do come to market are happening much further along in a company’s life cycle. In fact, the number of stocks in the S&P 500 with sales growth above 15% has dropped from almost 225 in the early 2000s to 66 today!
Exhibit 2: Technology IPO Issuance: 25 Years ending 12/31/19
Pulling back our lens even further, we see that the number of public companies, in general, has significantly decreased. As seen in Exhibit 3, there were over 8,000 publicly listed companies in the mid-1990s. That number has fallen to under 5,000 today. This compares to the universe of companies backed by private equity, which stands at over 26,000.
Exhibit 3: Comparison of Publicly Listed Stocks and Private Equity
Therefore, expanding one’s investable universe to include private equity increases an investor’s opportunity set, both in general and within the high-growth company category.
Opportunities Created by COVID-19 – Middle Market Private Equity Investing
In general, BMT believes a focus on middle market companies has the opportunity to create the best performance results within private equity. We see the opportunity set as larger, with less mega-cap private equity funds chasing these opportunities, and private equity managers with true operational expertise can have a material impact on the growth trajectory of these smaller companies.
Today, investors have an opportunity to allocate to middle market private equity at the inflection point of an economic cycle in the aftermath of the COVID-19 pandemic. Private equity managers are already taking advantage of decreased valuations as more private companies seek investment capital during the current market dislocation. Mid-market companies were engines of economic growth during recoveries following past downturns and delivered outsized returns for private equity investors. Exhibit 4 shows this using performance data from funds raised from 2009 through 2012 (post-Financial Crisis).
Exhibit 4: Comparison of Mid/Small Buyout vs. Large/Mega Buyout
In general, history has shown that crisis and post-crisis vintages have produced relatively higher returns, which is illustrated in Exhibit 5.
Exhibit 5: Private Equity Returns by Vintage Year: 1999-2014
In this environment, mid-market companies are increasingly receptive to outreach from potential private equity investors (especially important due to the relative scarcity of capital from traditional sources like banks). We believe targeting private equity managers with a strong operational skillset is likely to produce the best results, as they can immediately add value to many of these mid-market companies.
Private equity managers are also using the pandemic as a chance to reassess their entire portfolio of companies – both existing investments and new opportunities. They are now able to ask critical questions and point capital to areas that can best facilitate growth. Going forward, what will the new normal be? What consumer behaviors will be impacted? What will supply chains look like? What new opportunities will emerge as a result of remote work? These questions are driving exciting change, growth, and innovation in private equity-backed companies.
We have always been advocates of diversification within more conventional asset classes. The same can be said for private equity investing, but there are some subtle differences that should be considered. While investors should aim to maintain diversification across geographies and sectors, spreading capital to a wide assortment of different strategies, especially using the same private equity firm (GP), can have mixed results. Many GPs are very proficient at analyzing deals within a specific strategy – mega-cap Buyout investing, for example. A lack of compelling opportunities, or an attempt to diversify, could cause a GP to allocate capital to strategies where they do not possess the same analytical edge or level of experience. This could lead to poor returns despite the presence of a well-diversified portfolio. Another attractive attribute of Capital Dynamics is the experience level and success the firm has had building portfolios across different segments of the private equity space, which are explained below.
Primary investments, or commitments, are the most prevalent and enable investors to gain access to a wide range of different private equity investments as fundraising commences. Most investments made within the private equity space are conducted via primary commitments. There are some disadvantages compared to other investment types, such as secondaries and co-investments. The investment horizon is longer, capital sits idle until it is called, and there is a lack of transparency pertaining to companies’ underlying portfolio. The reputation of the manager’s ability to invest in quality companies is the primary factor determining the attractiveness of primary investments.
Secondaries have a different structure in place and involve the buying and selling of pre-existing investor commitments to private equity funds. One of the main advantages is that investors can more quickly deploy assets to the private equity space, thus expediting drawdowns of capital. Secondaries can also mitigate the J-Curve effect (see below) and enable more diversification across vintage (see below) years. One of the downsides is that secondaries often have higher fees. Also, auction driven transactions are typically completed at higher valuation multiples, which can lower returns during the exiting phase of the investment. However, firms such as Capital Dynamics can focus on smaller transactions and rely on their network of private firms to source transactions in an effort to get better pricing.
Co-investments are the last type of private equity investments, which arise if the fund manager underestimates the amount of investor capital needed to complete a transaction. Existing investors are often given the opportunity to allocate more capital than what was previously required and do not pay additional management or performance fees. These deal structures are a cost-effective way of increasing one’s allocation to a particular private equity investment.
The Capital Dynamic strategy holds a mix of the three different private equity approaches, which we believe will lead to improved risk/adjusted returns over time.
A term unique to the private equity space is “vintage year,” and no, we are not working as vintners in our spare time. As with virtually any investment, deploying capital to the private equity space at a particular time can result in materially different return outcomes. For those looking to make investments into multiple deals, we believe that it’s advisable to maintain diversification across vintage years, which refers to the year in which the first investment is made, thus formally establishing the starting point for the investment window (usually 10-12 years). Large allocations in one vintage year can increase the risk profile of the overall portfolio. In addition, private equity fund lives are split into an investment period that typically lasts five years and a subsequent harvesting period – the time when the manager starts selling assets in the fund. Private equity fund investments are not made in one lump sum, but rather the committed capital is deployed over several years. While this gives the managers a fair amount of flexibility to time their entry and exit points, we still think it makes sense to maintain diversification across vintage years.
The “J-Curve” effect is another term widely used within the private equity world. It’s also commonly found in economics to show asymmetry, or non-linearity of a data series, which form a “J” when plotted on a chart. Cash flow to investors in private equity funds resemble this pattern, as seen in Exhibit 6.
Exhibit 6: Example Cash Flow Distributions for a Sample Private Equity Funds: 2009-2019
Even top-performing private equity funds will have negative cash flows during the first few years of investment. The reason for this is that during the early years, investors have not had all of their capital called, so it’s not generating any return. While this is occurring, a material portion of the capital that has been called is being used to pay transaction costs, fund asset improvement projects, and go toward other expenses. This is also occurring while investors are paying management fees to the private equity managers. However, when this pattern reverses and cash flows begin to increase, the pace at which this occurs is not gradual and often takes place quite rapidly – hence the cash flow distribution is typically the shape of a J-Curve.
One way to somewhat mitigate the J-Curve effect is for private equity managers to own some secondaries in their portfolio. The reason for this is that a secondary investor acquires an existing interest in a private equity investment, which in some cases is completely funded and is in the process, or close to being cash flow positive. In addition, it is possible to buy secondary assets at a discount to the net asset value (NAV). The discount can occur because sellers may urgently need capital.
The illiquid nature of private equity investments, often including capital commitments of around 10 years, is perhaps the most important consideration when deciding whether or not private equity is appropriate for a given investor’s portfolio. Not only does this lack of liquidity prevent an investor from drawing upon this capital for an extended period of time, but it becomes more difficult to divest from the investment should the manager underperform, or should a potentially more attractive opportunity present itself.
Investors tend to be compensated for this illiquidity. When discussing private investments, the term “illiquidity premium” is often used. Simply put, this is the extra return these investments need to offer investors to compensate them for locking up their capital. Exhibit 7 demonstrates this phenomenon, with return expectations for private (more illiquid) investments much higher than traditional (liquid) public markets. Past performance trends would support the view that private markets have, in fact, offered this return premium.
Exhibit 7: Example Cash Flow Distributions for a Sample Private Equity Funds: 2009-2019
In terms of a typical timeline for capital commitment, a good rule of thumb is the following:
- An investor will typically have a dollar amount less than their overall committed capital exposed to private equity at any given time.
- The overall capital commitment is “called” by the private equity manager for investment during the first 1-5 years.
- Investors will have usually received all their initial commitment back in the form of distributions by year eight, with the partnership fulling winding down between 10-15 years after its inception.
- This timeline will vary depending on the private equity investment, but it lends itself to rolling commitments to private equity to maintain a consistent exposure. That is the approach that BMT takes when allocating client portfolios to the asset class.
If an investor opts to make a private equity investment, there is specific documentation that must be reviewed and signed before capital can be allocated. Investors are required to review the Private Placement Memorandum, which includes all relevant information pertaining to the offering, as well as background information about the firm that will be managing the assets. An Operating or Fund Agreement, which specifies the private equity firm’s obligations to its investors and corporate governance structure, must be signed. In addition, investors must complete a Subscription Agreement that indicates the amount of capital that will be committed, along with other documents that attest they are an accredited investor.
The volume of documentation can be overwhelming, but we will assist clients with any questions or concerns regarding any of the “closing documents” they are required to review and/or sign. Clients should also consult with an accountant or tax attorney to get a better understanding of all tax-related matters pertaining to investments in private assets. Finally, investors will receive periodic updates about the value of their private equity investments, but the reporting is infrequent and not nearly as transparent relative to public markets with daily pricing.
Another unconventional feature of private equity is that investments are not made in one lump sum. There are two distinct periods over the lifespan of a private equity fund. First, there is the investing period when capital contributions are made by the investor over a 3 to 5-year commitment period to fund new projects and cover administrative expenses and management fees. General partners will issue “capital calls” as funds are needed. Unfortunately, the timing can be very hard to predict and generally must be met within a ten-day period once they are issued. Then there is the harvesting period, which is the time investors start receiving distributions from the fund, which combine their original investment and any gains that are realized, minus any fees paid to the general partner overseeing the assets.
Private equity fees are high, especially when considering that one can buy an equity ETF that has an expense ratio of virtually zero. However, a case could easily be made that these fees are justified, given their favorable relative returns compared to public equity markets. When analyzing the fee structure, you will see something like this “2-20-8”. The “2” refers to the management fee, which typically ranges from 1%-2% of the total amount committed by the investor. The “20” refers to the incentive fee (%), or carried interest, which is the general partner’s share of the profits that are realized. This percentage can be as low as 5% or as high as 30%. The “8” is the hurdle rate (%), which is the minimum rate of return an investor must earn before the general partner is permitted to start earning carried interest. The typical hurdle rate is normally 8%-10%. The way it is calculated may differ across private equity firms. Sometimes it is based on the return of invested capital, while other times it can be based on the IRR (see below) of the fund on a specific date.
The rules governing how carried interest will be paid are specified in the closing document. The term “waterfall” is used to describe how carried interest distributions are made to the general partners. First, there is the recovery period where limited partners (investors) receive all the distributions up to the amount they invested minus any applicable management fees. Then investors receive all the profits up until when the hurdle rate has been met. Once the hurdle rate has been eclipsed, general partners receive all or a large percentage of the gains until the total amount of profits falls in line with the original 80/20 split. After this “catch up phase,” profits are split in accordance with the 80/20 stipulation. A general partner’s share of the profits can be “clawed back” if future losses are incurred by the fund.
The following example may provide clarification. Say an investor has a $1 million commitment. The first million distributed is just returned to the investor without any carried interest payments. Say the hurdle rate is 8% and the fund distributed an additional $80,000, the general partner is not entitled to any carried interest – 8% x $1 million is $80,000. In the future, another $100,000 in distributions are realized. Intuitively, you would think the general partner would receive $20,000 ($100,000 x .20). However, the total profits realized at this point are $180,000, which means the general partner is entitled to $36,000 ($180,000 x .20). The investor payment is $144,000 and the private equity fund manager is entitled to $36,000, which equates to 36% ($36,000 / $100,000) during this round of distributions. Going forward, all future distributions will be split 80/20 in accordance with the carried interest provisions highlighted earlier.
 A new decade for private markets: McKinsey Global Private Markets Review 2020, page 7
 Capital Dynamics
The views expressed herein are those of Bryn Mawr Trust as of the date above and are subject to change based on market conditions and other factors. Past performance is no guarantee of future results. This publication is for informational purposes only and should not be construed as a recommendation for any specific security or sector. Information has been collected from sources believed to be reliable, but has not been verified for accuracy.
Investments in private equity are less liquid than publicly traded securities. Investors should be prepared to remain invested for a prolonged period, which may extend over periods of market volatility. The periodic valuations of privately held companies is generally at the discretion of the investment manager and may not be reflective of the true market value for the company.
Capital Dynamics Group is an independent asset management firm focusing on private assets and comprises Capital Dynamics Holding AG and its affiliates. The information contained herein is provided for informational purposes only and is not and may not be relied on as investment advice, as an offer to sell, or a solicitation of an offer to buy securities. Any such offer or solicitation shall be made pursuant to a private placement memorandum furnished by Capital Dynamics. Further, this document may contain information that has been provided by a number of sources not affiliated with BMT or Capital Dynamics. BMT and Capital Dynamics have not verified any such information.
Nothing contained herein shall constitute any representation or warranty and no responsibility or liability is accepted by BMT or Capital Dynamics as to the accuracy or completeness of any information supplied herein. This document may contain past performance and projected performance information. It must be noted that past performance and projected performance is not a reliable indicator or guarantee of future results and there can be no assurance that any fund managed by Capital Dynamics or investments managed by BMT will achieve comparable results.
The contents of this presentation should not be construed as legal, tax, accounting, investment or other advice. Each investor should make its own inquiries and consult its advisors as to any legal, tax, financial and other relevant matters concerning an investment in any fund or other investment vehicle.
When considering alternative investments, such as private equity funds, you should consider various risks including the fact that some funds may use leverage and engage in a substantial degree of speculation that may increase the risk of investment loss, can be illiquid, are not required by law to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, often charge high fees, and in many cases the underlying investments are not transparent and are known only to the investment manager. Any such investment involves significant risks, including the risk that an investor will lose its entire investment.