Why Private Equity?

In addition to driving growth and improving the performance of the companies in which it invests, private equity has historically delivered superior returns relative to other asset classes over the long term. Private equity moves in cycles but has a long-term investment horizon.

The strongest argument for private equity is the long-term historical track record achieved by the industry’s top-performing managers. Over the ten years ending June 2013, top-quartile U.S. private equity firms generated annual returns of 21.0% (Thomson Reuters), compared to 7.5% for the S&P 500 and 9.4% for the Dow Jones Industrial Average. Private equity returns have helped strengthen the investment performance of many public and private pension fund, labor union, charitable foundation, and university endowment plans that have invested in the asset class over the long term.

There are diversification benefits that can result from including private equity in an institutional investment portfolio. Several studies have shown that portfolios with an allocation to private equity have historically delivered higher returns with only a moderate increase in risk. Because of the long-term nature of the asset class, private equity cycles do not necessarily move in direct correlation to public markets. Private equity also provides institutional investors with access to a private, less-efficient market, taking advantage of pricing disparities. The global universe of private companies available to investors is far larger than that of public companies. Institutional investors that invest in private equity can gain exposure to carefully selected and efficiently structured companies with strong corporate governance and growth potential.

How Does Private Equity Work?

Most traditional private equity funds pool capital from various investors (known as limited partners) to create a portfolio of approximately 10 to 30 privately-held companies over an investment period of three to four years. The private equity firm manages the portfolio by investing time, expertise, talent, and capital to improve performance and enhance the value of each company.

More than just a financier, many private equity managers are active investors, holding board seats and engaging on a regular basis in the management, strategic marketing, and mentoring of their companies. Because the funds have finite lives, an exit outcome is necessary to monetise the investment. The reward is typically received after four to seven years when the company is liquidated or realised. This can be achieved by a sale to a strategic or financial buyer or by completing an IPO (offering public shares of a formerly privately-owned company on a public stock exchange). Once the liquidity event is achieved and the private equity manager receives proceeds from the sale or IPO (targeted to be in excess of the original investment amount), it then distributes the cash or stock back to its investors.

Finally, a private equity fund typically has a term of approximately ten years, after which it may be extended in order to fully liquidate the portfolio. As an illiquid investment, it is important to note that investors may begin to receive capital back as underlying company exits occur, even as they are still investing capital to support companies that require additional funding to grow. The offsetting nature of these cash flows can result in an investor’s net investment at any one time being lower than the original commitment amount. Investors often try to manage their level of exposure to private equity and may employ an over-commitment strategy.