Over the last 60+ years, private equity investing has developed from the original leveraged buyout deals, once the unproven territory of financial pioneers, into a tried and tested investment philosophy. Opportunity for investing in the asset class has grown considerably, with a multitude of strategies available across all stages, sectors and geographies.
The private equity philosophy has been successfully adapted into asset strategies such as real estate and natural resources as well as in related strategies in credit and distressed investing. Today the combined AUM amounts to $12.2tr, as shown in Figure 1. Private equity buyout is the largest component of private equity and is the focus of this article.
Figure 1: Preqin Private Asset Managers AUM from 2000 to September 2022
The fundamental concept of private equity is making a control orientated investment in a company which is not publicly listed. Today, most private equity investing is done through funds of pooled investor capital managed by a private equity firm. The private equity strategy is to identify and acquire private companies or assets with a clear investment thesis, implement initiatives to create intrinsic value during ownership, and then exit the company or asset at a multiple of cost.
What may surprise people, is that private equity has been involved in some of the most well-known companies globally including: Formula One, Hugo Boss, Walgreens Boots Alliance, Dr. Martens, Stada and Breitling. Interestingly, private equity was the owner of the first three companies during the 07-08 financial crisis and the latter three through the Covid-19 pandemic. Private equity firms were responsible for making transformational changes and decisions which allowed these companies to weather the storm and emerge strongly into the market leaders they are today.
What makes Private Equity an Attractive Asset Class?
Private equity is an asset class favoured by the world’s leading institutional investors. Some of the largest public and private pension funds, sovereign wealth funds and the endowments of universities such as Yale, Harvard and MIT have been long term investors. Private equity has a number of attractive qualities which appeals to these types of long-term investors.
The defining characteristics of private equity can be described by Three C’s: Class, Control and Creativity
Class. The private equity approach can be applied to a wide variety of companies across a range of geographies and sectors. These companies can span from the ‘best in class’:
- Market leaders: top players in their respective sectors with strong market share and high barriers to entry which allows this position to be maintained. Existing management team is typically strong but may need to be augmented.
- Essential: companies that provide mission critical products and services in sectors like healthcare, financial services, and technology. Revenue is less cyclical and switching cost for customers can be high.
- Value creation potential: capitalise further on existing markets, expand internationally, improve costs, or execute accretive M&A.
Right down to companies which are inherently more complex or have specific challenges to overcome. These are often considered to have ‘top class potential’ with significant scope to be improved:
- Ownership or management challenges: corporate orphans, misaligned shareholders, underperforming or unsuitable management team.
- Distressed or misunderstood: can have very specific issues around their capital structure or may be in sub-sectors that are niche or difficult to understand.
- Value creation potential: realign focus & shareholders, bring in A+ management teams, sort through complexity and restore performance.
Control. This is the best way to implement change. Private equity firms can choose to expand into new countries, develop new products, scale companies up or down depending on market environment, implement cost saving initiatives, buy complementary businesses or sell non-core divisions. Company management can be changed where necessary but private equity firms recognise that having an aligned team is essential to achieve transformation and value creation. This control allows for decisions to be made quickly and decisively. The scale and resources of leading private equity managers allows them to implement these broad initiatives or widescale changes effectively. This compares to a more broadly owned company which has shareholders with different agendas. Decision making can be much slower and can often lack the desired direction (in an effort to keep all parties happy).
Creativity. Private equity firms have the ability to be flexible in both where and when they invest. They can react to market cycles to pursue the best opportunities. As private equity funds are long-term investment vehicles, managers can be patient in when they invest, deploying funds over a period of 3-5 years depending on the environment. This allows managers to cut out the daily noise and instead listen clearly for growth opportunities over a longer time horizon. This creativity extends to how they source, diligence and structure deals. Companies can be sourced off market or when there is a more competitive process managers have either been tracking the company for a long time or have a specific angle to differentiate themselves. Access to private information and management during the due diligence process allows for detailed and prudent underwriting of companies where both performance and people risk can be analysed. When acquiring companies private equity managers tend to structure deals with a focus on downside protection, utilising sensible leverage that is often obtained on favourable terms.
It is the combination of these Three C’s that makes private equity attractive across market cycles.
Historical Performance of Private Equity
The historical performance of private equity has been strong. Figure 2 compares the performance of a global private equity buyout index and a global public equity index over a 5, 10 and 15 year time horizon. It highlights that private equity has meaningfully outperformed public equity over a number of different time periods.
Figure 2: Preqin Global Private Equity Buyout Index and MSCI World Total Return Index, 5, 10 and 15 years annualised performance to 31 December 2022.
This outperformance has also occurred with less observed volatility. Due to their more illiquid nature, private equity funds are valued quarterly versus listed equities which are priced daily. An overbearing focus on liquidity can often be a distraction and not serve investors well. The ability for an investor to buy or sell on a daily basis can result in adverse market timing decisions or panic induced decisions. These decisions can become particularly adverse during more turbulent markets if timing is driven more by fear than sound rationale. The private equity approach focuses on the longer-term for value creation and is less concerned with daily valuations. Only two valuation points really matter, the valuation private equity managers buy the company at and the valuation when they sell it.
The performance of the pooled investor funds for the vintage years 2017, 2012 and 2007 has also been strong. Figure 3 outlines the performance on a quartile basis for these private equity fund vintages. The typical term of these funds is c.10 years, so the 2012 and 2007 vintage performance are in the main realised whereas the 2017 performance will continue to evolve in the coming years.
Figure 3: Global Private Equity Buyout Fund Performance by Quartile for years 2017, 2012 and 2007. Total Value to Paid-In (TVPI) and Net Internal Rate of Return (IRR).
One aspect that tends to be more pronounced in private equity versus more traditional asset classes is the dispersion of performance between top and bottom quartile managers. For the more mature 2012 and 2007 vintages, top quartile managers have almost generated an additional 1x of TVPI return and an incremental net IRR return of 15.4% and 12.1% when compared to the respective bottom quartile managers. This highlights that in order to be successful in private equity investing it is essential to partner with the top managers who can consistently outperform across vintage years.
The longevity, value-add characteristics and historical performance of private equity serve to make the asset class attractive for institutional and individual investors alike. As a next step a prospective investor may want to explore: the different routes to accessing private equity funds, how private equity managers are navigating the current market environment and the venture capital asset class, which has increasingly grown as a source of private investment for new companies.
Author: Conor O’Dea, Director, Key Capital Investment Management. To find out more contact your financial adviser or J.P. Maguire, Business Development Director, Key Capital Investment Management +353 1 638 3850 firstname.lastname@example.org
- Preqin Private Asset Managers AUM from 2000 to 2022 as accessed May 2023.
- Preqin Global Private Equity Buyout Index to 31 December 2022 (latest index valuation available) as accessed May 2023. MSCI World Total Return Index to 31 December 2022 from Bloomberg.
- Preqin Private Equity Buyout Fund Performance by Quartile for years 2017, 2012 and 2007. As accessed May 2023.
Past Performance is not a reliable guide to future performance.