The allure of Private Equity

Believe it or not, there’s big money in caravans. Citywire reports that the investment company Electra Private Equity has enjoyed the happiest of new year’s courtesy of deal-making in the caravan park sector at the end of 2016. The closed-ended fund got a big boost when Parkdean Resorts, in which it owned a sizeable stake, was sold for £1.35bn.

Caravan holidays might be the last thing on your mind with much of Britain in deep freeze right now, but the transaction is a reminder of the attractions of the private equity sector. It gives exposure to privately-owned companies capable of growing rapidly – given the right support – and delivering a return that you would be hard-pressed to find from a business listed on the stock market.

Traditionally, private equity managers have operated through limited-life partnerships open only to institutions or very high-net worth individual investors. These partnerships draw down funds from investors as and when money is needed – that makes it impossible to operate with hundreds or even thousands of investors.

However, the development of the listed private equity sector over the past decade or so has democratised this asset class.  It is now possible for any investor to buy exposure to private equity assets that were once the preserve of the institutions.

Why would they do so? Well the allure of private equity is that managers work with exciting businesses that have huge potential. These companies are typically at an earlier stage of their development than their quoted counterparts – investors are effectively getting in on the ground floor of their journey upwards.

Often, the private equity manager is the catalyst for a rapid acceleration of the business’s growth. Managers typically take a seat on the board and work with the company – this means they must be more than simply good stock pickers capable of identifying companies with strong business models, though this is an important part of the job. They also need the right experience and skills to work with the companies in their portfolios – it’s a hands-on process.

That’s not to say the work always pays off. Private equity is a riskier asset class than, say quoted companies. When an investment disappoints, the fund can’t just sell up and move on to a new investment – the problems must be worked through and resolved.

This is also why closed-ended funds are a natural way to offer exposure to private equity; in an open-ended fund, where the manager has to cope with inflows and outflows of investors’ money, managing such illiquid assets would be problematic.

Investment companies can also deploy gearing, borrowing some of the funding needed to finance their investments in companies. Gearing enhances the returns on profitable investments, though it also exaggerates the losses when companies fail.

Some downside protection for investors comes in the form of diversification, given that the fund will hold a portfolio of investments, but private equity fund performance is rarely linear – returns can often be lumpy, particularly since the underlying assets aren’t valued every day. Still, the Electra deal underlines the point that when things go right, the results can be dramatic – its shares are currently around 40 per cent up on a year ago.