An overview of private equity

Private equity explained

Private equity, quite simply, is company ownership where the ownership isn’t listed on a stock exchange, but rather is transacted privately. Private ownership enables a company’s management to focus on sustainably growing their business over the long term, rather than focussing on quarterly earnings cycles and short-term drivers of valuations that their listed counterparts endure. Private companies are also immune from the heightened public scrutiny placed on listed entities. By taking a long-term strategic view to performance, private companies can offer the potential to generate attractive, long-term returns.

Figure 1 – high level differences between private and public ownership

Source: Schroders, 2020

Private equity investment offers access to companies that are diverse in stage and size - and are otherwise difficult to access. It fuels the growth of early stage companies at start-up and into their growth-phase, through to buyout and turnaround phases. This access to growth and transformation transactions across the company lifecycle can boost private equity performance when compared to listed market companies as public markets typically only cater for larger company sizes which can afford to deal with the complications of listing on a stock exchange, as depicted in Figure 2. 

Figure 2. A company’s capital requirements throughout its lifecycle

Source: Schroder Adveq, 2019

The private equity universe eclipses the public market in size

Over the past two decades, the number of listed companies in certain markets has fallen significantly. Figure 3 shows the decline in listed companies on the US and UK exchanges over time. Note: the data also includes the delisting of companies due to underperformance or other factors.

Consequently, more private companies are available for investment. For example, across the stock exchanges of the US, Europe, Canada and Asia, the healthcare sector has an investment universe of less than 3,000 listed companies. In contrast, in the same markets, there are around 146,000 privately held investment grade healthcare companies.

One factor that keeps companies private for longer is the cost of meeting the increasing oversight and disclosure requirements imposed upon them by securities regulators. Figure 4 shows how the number of words in company 10-K disclosure filings (the US’s annual reporting requirement) have increased over time, implying the effort and resources listed companies  must invest into is increasing in order to comply with the relevant regulations.

Figure 3. Number of listed companies in the US and UK over time

Source: London Stock Exchange, Schroders. World Bank World Development Indicators (WDI) and World Federation of Exchanges. Note: Data to end 2018. UK figures are for main market only.

Figure 4. Number of words in 10-K disclosure filings over time

Source: The Evolution of 10-K Textural Disclosure: Evidence from Latent Dirichlet Allocation, Travis Dyer, Mark H. Lang and Lorien Stice-Lawrence, SSRN 2741682, March 2016.

Higher returns may be available in private equity

Private equity investments have the potential to outperform  listed equities and many other asset classes for several reasons:

• Expanded opportunity set and non-public information. The larger investment universe, combined with access to non-public research insights, gives private equity fund managers an advantage in portfolio construction.
• Lower entry prices. Private equity companies typically trade at lower purchase multiples than their listed counterparts. Furthermore, buyouts of smaller companies have historically traded at more attractive purchase multiples than buyouts of larger companies, as shown in Figure 5.
• Company value is unlocked through intervention. Private equity investment in a company typically involves a board position and influence over company direction. For small, family-owned companies and start-ups with low management capability, significant value can be created by leveraging the expertise housed within private equity firms. Company inefficiencies are solved, growth is accelerated, and costs are reduced through customer expansion, M&A activity, managing cash, attracting talent, and improving IT systems.
• Private markets have an illiquidity premium. The trade-off for holding assets that are less liquid is the expectation of a higher return as compensation.
• Lower levels of volatility versus listed counterparts. The valuation frequency and valuation methodologies mean the volatility on these strategies is also far lower than their listed counterparts.

Figure 5A and 5B: Pro forma trailing EV/EBITDA purchase multiples small and large buyouts (US and Europe)

EV/EBITDA purchase multiples small and large buyouts (US)

EV/EBITDA purchase multiples small and large buyouts (Europe)

Past performance is not a guide to future performance and may not be repeated.

Source: Baird 2019, S&P 2019, Schroders 2020.

Small vs large fund manager returns

In a market with a large range of return outcomes, choosing the right private equity manager is critical to achieving top performance.

Smaller funds generally offer the greatest opportunities for outperformance but also pose a larger risk of underperformance. At the other end of the spectrum, the biggest funds may on average reduce downside risk, but possibly at the expense of returns.

Figure 6 shows the top 5%, top quartile, median, bottom quartile and bottom 5% of IRR split by fund size across the private equity universe. As the graph shows, the median across the range is very consistent, and the returns start to compress as you move into the jumbo (>$/€1 billion) fund size. 

The graph also shows that where you can find outperformance is in the smaller size funds. However, with these smaller size funds comes the opportunity for underperformance, so that is why manager selection, especially in the smaller size of the market, is paramount.

Figure 6: IRR by fund size

Past performance is not a guide to future performance and may not be repeated.

Source: Schroders, Burgiss, August 2020. IRR data from Jan 2000 – March 2020 from fund vintages between 2000-2016.

Private equity is now available to more investors

Traditionally, private equity investments were held by large professional investors such as pension funds, family offices and asset managers. With large investment minimums, the requirement to meet periodic and irregular calls for capital and the inability to access the investment for up to 10 years, other types of investors have historically been excluded from private equity investment. In addition, barriers such as a lack of transparency and understanding of the asset class, combined with complicated fee structures, have prevented retail investors from accessing this asset class.

To make this asset class available to a broader range of investors, fund managers like Schroders, have developed private equity funds with accessible features. Innovations include:

• Funding the investment in full at the outset rather than via periodic and irregular capital calls
• Holding a portion of cash within the fund to give investors a degree of access to their capital on a quarterly basis in case of a change in circumstances
• Reducing investment minimums
• Making the asset class available via wrap platforms

The opportunity for private equity

The benefits of this asset class include:

• Potential for higher long-term returns: As mentioned previously, private equity has the potential to outperform listed markets due to the expanded opportunity set, lower entry prices, board intervention and liquidity premium.
• Diversification: Access to a broader universe of companies and the low correlation to listed markets provides investors with diversification away from traditional listed equity and fixed income markets
• Stability during times of market volatility: Fund managers have a higher degree of flexibility and the opportunity to intervene in the operations of their portfolio companies in times of crisis.

How to incorporate private equity into portfolios

Figure 7 shows the performance, volatility and correlation of Schroder’s private equity portfolio compared to other major equity indices. As this shows, private equity can have the ability to outperform listed markets with lower volatility and only a moderate correlation to public markets.

Figure 7: Schroder Adveq track record versus MSCI World TR

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Source: MSCI, Schroder Adveq, 2020. Figures shown are as of Q2 2020 and net of underlying fund fees, expenses and performance fees and gross of Schroder Adveq’s fund fees, expenses and performance fees, as calculated in $. Quarterly returns calculated as the total quarterly investment result over the Beginning of Period (BOP) NAV. The total quarterly investment results are calculated as End of Period (EOP) NAV plus Distributions in the quarter minus Calls in the quarter minus BOP NAV.

Due to its unique investment universe, valuation methodologies and moderate correlation to listed markets, private equity can be used as a portfolio diversifier and when used in a portfolio with other assets, private equity can have a cushioning effect.  Figures 8 and 9 show how private equity may be incorporated into investment portfolios, giving the opportunity to enhance returns and either diversify growth assets or form part of an alternatives allocation.

Figure 8: A component of a growth allocation

Source: Schroders, 2020

Figure 9: A component of an alternatives allocation

Source: Schroders, 2020

The Schroder Specialist Private Equity Fund

The Schroder Specialist Private Equity Fund offers access to the expertise of Schroders’ dedicated private equity team, Schroder Adveq. Schroder Adveq’s pedigree in private equity, coupled with Schroders’ 200-year heritage, makes us ideally suited for investors looking for longer-term investment opportunities such as private equity.

The Fund focuses on small to mid-cap specialist opportunities across the US and Europe, as well as Asian growth companies. We believe this segment has the opportunity to outperform the wider private equity market and sets the fund apart from others available to Australian investors. Now available via wrap platforms, the fund can be easily incorporated into client portfolios.