Introduction to Private Equity (CA)

This whitepaper is an introduction to private equity, as well as, real life case studies of private equity. The whitepaper will cover topics including:

  • What is private equity?

  • How are returns generated?

Download the whitepaper above to learn more. 


Executive Summary

Private equity can play an important role in institutional portfolios. This typically makes up only a small allocation but can be one of the largest contributors to overall return.

Historically, data has shown clear out performance of private equity relative to public equity over the long term (15 years). Investors typically invest in private equity alongside public equity.

Over the past decade, the number of companies opting to remain private has increased meaning the opportunity set for private equity managers is better than ever. This will help managers construct a fully diversified portfolio of companies, accessing firms that are off limits to public equity managers.

Unlike traditional public equity managers who buy securities which they expect to increase in value, private equity managers can take control of businesses and, through their changes, create value. As private equity managers drive value, returns are less dependent on broad equity market movements and are dependent on the skill of the manager.

Within private equity, investors often invest in buy- out and turnaround strategies which involve investing a majority stake in companies that require strategic work or restructuring. We would advise clients to select managers with proven expertise in these areas.

We encourage investors to consider an allocation to private equity to diversify their overall equity allocation. Even a small allocation to private equity can have a large contribution to overall return.

What is private equity?

Private equity is an investment that involves a purchase of part, or all, of a company that is not listed on a public stock exchange. The investment is used to enhance value and improve performance before being sold for a significant profit.

Private equity investing evolved from the requirement from early stage companies for private capital to help growth.

In recent years, there has been an increase in private equity investing due to the attractive returns, increased focus on governance and volatile public equity markets.

Performance relative to public markets

Over the long term, private equity has outperformed public equity markets. Returns are typically paid back over the life of the investment as stakes in companies are sold. Based on our Capital Market Assumptions over the next 10 years, we expect global private equity to return 8.6% p.a. with volatility of 25.0% p.a., relative to global public equity returns of 6.8% p.a. with volatility of 14.6% p.a.

Lifecycle of a private equity fund

Creating value takes time hence a private equity fund is usually an illiquid fund structure with a life of approximately 10-12 years.

After an investor has committed to a fund, capital will be drawn down periodically as portfolio companies are purchased, this is the investment period. This period usually lasts for five years.

The manager will make enhancements to the business before selling it and the proceeds are returned to investors.

Use of managers

Investors typically employ specialist private equity managers who have experience in increasing the value of businesses. These managers typically invest their own capital alongside capital of outside investors and build a diversified portfolio of companies.

How returns are generated

Private equity managers have several unique return levers relative to traditional equity and bond managers. The below features apply in the context of individual businesses which are then combined into a private equity fund.

Inefficient market / private information

Although private equity managers often invest in companies through auction processes, they also can access companies through direct negotiations with their networks.

The lack of public information generally allows skilled managers to gain advantages over other investors at purchase—from sourcing opportunities to pricing.

Active management

Taking majority control positions in a company and having board representation allows private equity managers to make changes to the company’s structure and strategy.

Managers can implement full or partial corporate restructuring initiatives. Restructuring can include, but is not limited to, changes to legal entities, ownership structures, operations, management teams (including the CEO) and merger and acquisition activity.

Wider opportunity set

Post the global financial crisis, the number of companies taking their businesses public has been decreasing largely due to a heightened regulatory environment. Many high growth and profitable companies, notably technology firms, are now remaining private for longer or do not plan to go public at all. Private equity managers are able to capture these opportunities to generate attractive returns.

Use of financial leverage

Private equity fund managers will often use borrowed capital (debt) to finance deals – referred to as leverage. The use of leverage can magnify potential profits as debt is cheaper than equity, however it can also magnify potential losses hence should be used with caution. The use of leverage has been cyclical, and although it has been going up recently, it is still lower than pre-financial crisis.

Top talent

Although private equity funds have relatively high management fees compared to public equity funds, the potential for large gains in terms of carried interest (profits from growing the business) allow private equity funds to offer top-tier remuneration to employees and attract high quality employees.

Aligned interest

Investment staff at most funds will commit capital alongside investors to ensure that the alignment with investors is strong. This provides a motivation for the team to add value and generate returns.

The ability to take a long-term outlook on companies and control liquidity

The life of private equity funds is typically at least 10 years. Managers make a long-term commitment on portfolio companies in comparison to public equity markets, where annual or even quarterly earnings changes are used to judge performance.

Managers also benefit from the flexibility of choosing when to sell portfolio companies, managers can hold onto companies through market downturns to limit losses.

Overcoming the challenges facing the industry

Historically, strong returns have attracted more private equity investors into the market, increasing market competition, however this can be mitigated by investing in top percentile managers.

The private equity market remains highly competitive with assets under management continuing to increase steadily. As of mid-2019 there were almost 4,000 funds in the market seeking an aggregate capital targeted of over US$ 1 trillion1, showing how crowded the fundraising market is.

Furthermore, record levels of dry powder, defined as yet-to-be-invested committed capital, mean there is a lot of capital already waiting to be put to work by managers.

Finding value is becoming increasingly difficult

Due to high demand, valuations have increased, hence a key challenge for managers will be finding value in competitive markets. Managers are having to pay more for companies, squeezing margins. Managers may look to source deals with exposure to emerging markets, which is predicted to account for 50% of global economic growth over the next 20 years.

Downward pressure of fees

The private equity industry is known for charging high fees to investors, traditionally a standard fee schedule is a 2% management fee and 20% carried interest. Carried interest is effectively a performance fee.

However, increased competition between fund managers and heightened pressure from the regulator has caused managers to be more transparent with fee schedules, offering fee discounts for first closers or offering a trade-off of a lower management fee for a premium carry. Although fees are still high, we’re seeing the right direction of travel in the industry.

The price of debt is rising

Post the financial crisis, private equity dealmakers have been able to source cheap debt financing which has bolstered investment returns. Debt financing is likely to become more expensive hence it will be ever more important to select high quality managers.

Manager selection is key

Given the increased competition, manager selection will remain paramount. Historically, there has been significant disparity between the returns of top performing managers and their peers. The internal rate of return (“IRR”) is a measure of an investment’s rate of return. The IRR chart shows that the top and bottom quartile funds can vary significantly (see chart below).

Market conditions make it critical for managers to source attractively priced deals. Top managers will be able to utilise their propriety networks to source deals at a good price.

Accessing private equity

Investors can gain exposure directly by taking equity positions in companies, or indirectly through a private equity manager.

Real life case studies

Below are examples of real life businesses that were bought by a private equity manager and exited for a profit:

Hilton Worldwide

Hilton Worldwide is a company that owns, operates and develops hospitality properties around the world. In 2007 a private equity manager saw an opportunity to add value.

The manager believed they could leverage their knowledge and skill set to improve the financial position of Hilton Worldwide, transform the business and expand rapidly. In 2007, the manager took the company private through a leveraged buyout.

Following the buyout, the manager replaced the CEO and the company shifted from the existing capital-intensive model of owning, operating and developing properties to a franchise model. This allowed the company to expand globally with minimal cost. In addition, the manager restructured the company’s existing debt to take advantage of lower interest rates.

In 2013, Hilton Worldwide went public again and has experienced strong growth since. The manager remained invested through the initial public offering (IPO) and continued to hold a stake until 2018. The manager was able to turn the business around and earned a profit of approximately three times the initial investment.

Dollar General

Dollar General is a discount retailer operating in the United States that offers low prices on everyday items.

By 2007 the company’s sales growth had lagged relative to competitors, stores were looking run down and popular items were constantly out of stock. A private equity manager believed the industry was strong and saw an opportunity to add value, purchasing the company in mid-2007.

Once acquired, the manager replaced existing management with experienced retail experts who used their expertise to streamline operations, improve store experiences and improve product offerings. Within two years business operations had improved.

Dollar General went public again in 2009 and was listed on the New York Stock Exchange. The manager remained invested through the initial public offering (IPO) and slowly exited the company over the following four years. By the time they sold their last shares in December of 2013 the stock price had almost tripled from the IPO price. Today, Dollar General operates over fifteen thousand stores across the United States.

Private equity in your portfolio

Private equity is an attractive asset class that is often overlooked; by choosing the right strategy and appointing a best in class manager the impact on return can be materially positive with the inherent risks mitigated.

We believe that if clients can afford the illiquidity, adding exposure to private equity is a great way to bridge a funding gap or contribute to fund returns. For clients that can tolerate higher risk and reduced liquidity levels, opportunities within private equity offer compelling risk-adjusted opportunities.

We generally advise clients to allocate no more than 5% to 10% of total assets to private equity, however specific plan circumstances may warrant allocations of 15% or greater. For large investors we would advise building a diversified private equity portfolio through the use of primary funds, while smaller investors may be best served using a Fund of Funds strategy.

Although margins are tightening and it’s becoming increasingly difficult for managers to find value, the private equity opportunity set is growing, and these risks can be mitigated by careful manager selection.

We see private equity fitting into client portfolios alongside a public equity holding. With the equity cycle nearing an end, we believe superior returns are generated by active management. Private equity offers the highest form of active management with managers driving changes and creating value.


About Aon Investment Research and Insights

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