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Private equity goes mainstream

11 October 2017

The asset class is no longer off limits to individual investors. David Prosser discusses whether you should consider it.

Is it time for more investors to consider private equity? This type of alternative investment continues to be popular with professional investors: one leading private equity manager, Hermes, has just raised $389 (£298m) from a group of international pension funds, including several prominent British schemes. In the UK, meanwhile, new research from FE Trustnet shows that amongst investment companies, those offering access to alternative assets, including HarbourVest Global Private Equity, are currently attracting the most interest from financial advisers and wealth managers.

The allure of private equity is that managers are taking stakes in unlisted, privately-owned businesses they hope will grow rapidly, delivering more exciting returns than conventional stock market investments. They invest clients’ money in portfolios of these businesses and the asset class has long been an important component of many professional investors’ spreads of holdings.

Your invite to the party

Naturally, retail investors have often been attracted to private equity too. But traditionally, private equity managers have operated through partnerships open only to institutions or very high-net-worth individual investors with large sums to invest. These partnerships draw down funds from investors as and when money is needed so it is impossible to operate with hundreds or even thousands of investors.

However, the good news is private equity is no longer off-limits to individual investors: listed private equity funds have changed that. These investment companies issue shares that are traded on the stock market. The shares offer exposure to the funds’ underlying assets – the same sort of portfolio of private equity holdings as the partnerships are buying.

Such funds have democratised the private equity industry. It is now possible for any investor to buy exposure to private equity assets that were once the preserve of the institutions, with more than 20 investment companies offering access.

The idea is that investors are effectively getting in on the ground floor of a business’s (hopefully rapid) journey upwards. The private equity manager can be a catalyst for an acceleration of the business’s growth. These will very often be companies that are not yet fully formed. They may lack good non-executive directors, for example, or be still to fully develop strong networks of suppliers, customers and other stakeholders. They may be operating without key functions such as dedicated sales and marketing teams, or struggling to cope with governance and management processes as their businesses grow.

Private equity managers take a seat on the board and work with the company to address these issues. It’s about helping businesses achieve their full potential – think of private equity-owned companies as rough diamonds; there is enormous value within that polish and refinement can reveal.

Risk versus return

That’s not to say the work always pays off. Investors in listed private equity funds need to understand this is a riskier asset than, say, quoted companies. When a fund makes a mistake, it can’t just sell up and move on to a new investment – the problems have to be worked through and resolved.

Moreover, private equity funds very often deploy gearing, borrowing some of the funding needed to finance their investments in companies. This debt is repayable by the companies themselves, so the private equity fund gets more bang for its buck from the money it puts into the business. Gearing enhances the returns on profitable investments, but also exaggerates the losses when companies fail.

Some protection for investors comes in the form of diversification. Since a private equity fund has a number of holdings, a poor performance from one of them should be disappointing rather than disastrous. Nevertheless, private equity fund performance is rarely linear – returns can often be lumpy.

Still, for investors comfortable with the risk profile of listed private equity funds – especially those able to invest on a long-term view – the compensation is the potential for superior long-term performance. Individual and institutional investors increasingly recognise that potential and are adding private equity holdings to their portfolios in order to boost overall performance.

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