When it comes to investing, there are a plethora of options available. From traditional stocks and bonds to alternative investments like real estate and commodities, the possibilities can be overwhelming.
One investment option that has gained traction in recent years is private equity. Private equity investments involve purchasing shares in privately held companies, often with the aim of helping these companies grow and become more profitable. While private equity investing can be complex and is often reserved for accredited investors, it has numerous potential benefits that make it an attractive option for many investors.
From this article, you’ll discover how and why private equity returns are higher than other assets and how including private equity in a portfolio benefits the risk-return profile.
Higher Returns
Private equity and public equity are two different types of investments that offer varying levels of risk and return potential. While it’s true that private equity investments have the potential to provide higher returns than public equity investments, it’s important to understand the reasons why.
One of the main reasons why private equity can provide higher returns is that private companies are often smaller and more nimble than public companies. This means that private equity investors can have a greater impact on the company’s operations and strategy, which can translate into higher growth and profitability.
Additionally, private equity investments typically involve a longer time horizon than public equity investments.
Private equity vs public equity: Statistical Comparison
The evidence suggests that historically, private equity investments have delivered higher returns than their public counterparts, often by a considerable margin.
Numerous studies have shown that private equity firms have consistently generated impressive returns, especially in comparison to publicly traded companies. This outperformance can be attributed to several factors, including the ability of private equity firms to implement strategic changes within their portfolio companies without the constraints of quarterly reporting and market pressures that publicly traded firms must contend with.
Take a look at annualized performance of private equity assets compared to conventional equities, by the indicator of returns, in the infographics below:
Private vs public equity — the net question
A recent analysis conducted by JP Morgan in 2021 has confirmed that the private equity industry continues to exhibit stronger returns than public equity. The study addresses a common criticism of the comparison between private equity and public equity, as it often includes alternative asset classes such as real estate, infrastructure, and energy, which can skew the data.
However, if we limit our focus to the three most common types of private equity – buyout, growth equity, and venture capital – the performance is indeed remarkable. In fact, Steve Kaplan, a professor at the University of Chicago Booth School of Business, has argued that these narrower definitions of private equity demonstrate significant outperformance compared to public equity.
Let’s also consider the growth rate of net asset value for global buyout funds (type of private equity investment) compared to the public equity market.
Private equity vs other asset classes
Private equity is one of several asset classes investors can choose from, including public equity, fixed income, real estate, and commodities. Compared to these other asset classes, private equity can offer unique benefits, such as higher potential returns, greater control over investment strategy, and a longer investment horizon. Private equity also offers a compelling risk-return profile with lower volatility compared to other high-return asset classes.
Let’s take a look at the graph for historic annualized returns against risk for different types of assets:
Exploring the Factors Behind the Strong Historical Performance of Private Equity Investments
The following factors drive returns from private equity funds up:
Access to market opportunities
As compared to public markets, the universe of companies available for investment in private equity is relatively large and largely untapped. Public companies are subject to extensive scrutiny, and by the time they go public, their value is likely to have already been recognized, leading to inflated prices.
In contrast, top private equity firms have access to a much larger pool of opportunities that are not yet widely known or subject to the same level of scrutiny. These firms have the resources to conduct in-depth research and identify which companies are worth investing in, and can invest in them at an early stage, when risk is higher but potential rewards are also greater.
By investing in companies at an early stage, private equity firms can benefit from higher returns when those companies succeed. While the risk is also higher, the potential for growth and profitability is significant, making private equity an attractive asset class for investors seeking strong long-term returns.
Active, value-adding ownership
Active, value-adding ownership is a key feature of private equity investments. Unlike passive investments, private equity firms take an active role in managing the companies they invest in, working closely with management teams to drive growth, improve operations, and increase profitability.
Private equity firms typically invest in companies with significant potential for growth and value creation, but which may be facing operational or strategic challenges. Through their deep industry knowledge and expertise, private equity firms are able to identify the key drivers of value in these companies and develop targeted strategies for improvement.
Alignment of interests
Alignment of interests is a fundamental aspect of private equity investments. Private equity firms typically invest significant amounts of their own capital alongside their investors, creating a strong alignment of interests between the two parties.
This alignment of interests helps to ensure that private equity firms are highly motivated to maximize the value of their investments. Because private equity firms have a substantial amount of their own money at stake, they are incentivized to take an active role in managing the companies they invest in and to make strategic decisions that will drive growth and profitability.
The Effect of Private Equity on Portfolio Risk
Private equity can have a significant impact on the risk profile of an investment portfolio. Because private equity investments are typically illiquid and have longer investment horizons than traditional asset classes, they can help to reduce overall portfolio risk by diversifying an investor’s exposure to market volatility.
Private equity investments are often less correlated with public market investments, such as stocks and bonds, which can help to reduce overall portfolio volatility. Additionally, private equity firms are often able to use their expertise to identify and mitigate risk factors in the companies they invest in, helping to reduce the risk for their investors further. In essence:
Private equity can provide opportunities for high returns that may not be available in traditional asset classes.
Private equity investments often involve active management and value creation strategies, which can result in greater upside potential for investors.
Private equity can offer exposure to a diverse range of industries and geographies that may not be available through public market investments.
However, it’s important to note that private equity investments also come with their own unique risks. Because these investments are illiquid, investors may not be able to access their capital for several years or even a decade or more. Additionally, private equity investments may be subject to greater regulatory risk, as changes in government policy or regulation can have a significant impact on the value of these investments.
Overall, while private equity can help to reduce portfolio risk through diversification and active risk management, investors should carefully consider the unique risks associated with these investments before adding them to their portfolios. It’s important to work with a trusted financial advisor and conduct thorough due diligence before investing in private equity.
Key considerations and risks for private equity investors
Management fees
Private equity firms charge management fees to cover the cost of managing their funds, which can be relatively high compared to other asset classes. These fees can range from 1% to 3% or more of the total assets under management, which can eat into the returns earned by investors.
High minimums
Private equity funds often have high minimum investment requirements, which can make it difficult for individual investors to access these types of investments. This means that private equity is often only accessible to institutional investors or high net worth individuals.
Low liquidity and delayed cash flows
Private equity investments are typically illiquid, meaning that investors may not be able to sell their shares or access their capital for several years or even a decade or more. This lack of liquidity can make it difficult for investors to respond to changes in their financial situation or to take advantage of new investment opportunities.
Risk of loss
Private equity investments come with a higher risk of loss compared to traditional asset classes. Because private equity investments are typically made in early-stage or growth-stage companies, they are inherently riskier than more established companies traded on public markets. This means that investors may experience significant losses if the companies they invest in fail to meet their growth targets or go bankrupt.
Valuation risk
Private equity investments are typically made in private companies that are not traded on public exchanges. As a result, valuing these investments can be challenging, and there is a risk that the investment may be overvalued or undervalued.
Concentration risk
Private equity investments are often made in a small number of companies, which can increase concentration risk. If one or more of these companies perform poorly, the entire investment can be impacted.
Exit risk
Private equity investments are typically illiquid, meaning that investors may have limited options to sell their shares in the investment. Additionally, the timing of an exit can be unpredictable, which can make it difficult for investors to plan their finances.
Final Take
Partnering with a trusted private equity company is essential for the success of your investments. Private equity investments involve significant amounts of capital and long-term commitments, making it critical to work with a firm that has a proven track record of success and a strong reputation in the industry.
A trusted private equity firm can provide valuable expertise in identifying and evaluating investment opportunities, performing thorough due diligence, and executing successful investment strategies. They can also provide access to their network of industry experts, enabling investors to leverage their knowledge and experience to make informed investment decisions.
Contact WhiteSails to get assistance with private equity and real estate investment from our team of well-seasoned niche experts.
