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Amazing Private Equity

 

Investing in companies that are privately owned has never been more popular. Last year alone, more than $453 billion (Reuters) was raised by private equity funds and even much more was invested through direct transactions. People often cite the higher returns when asked why they would choose to lock up their monies, rather than buying and selling shares in an instance on an exchange. Many family offices like to invest, because they think they know a bit about building businesses. After all, most have their roots in some form of entrepreneurship by a previous generation that made the money in the first place.

 

But does investing in companies that are private versus public really unlock a premium, and more importantly does the price justify the exposure? To answer these questions, we need to start with a more holistic understanding of the investment strategy. Companies make widgets. Whether, these are consumer goods, bakery products or financial services, in one form or another a business is nothing more than making a product and selling it to someone else. Revenues, profits and all that wonderful stuff that comes from scaling this proposition have absolutely nothing to do with whether you have one dude owning it, or several others. Yes, we can talk about the indirect effects of strategy, transparency, and leadership. But ultimately a good business is, making a product and finding people who are willing to pay you more for it than it cost you to make it.

 

What about the size effect? Well, yes here the market is quite fragmented and different sizes of companies are held in private hands. Some are worth billions and others millions, and the risk is quite different from holding a smaller business in their early growth stage versus an established behemoth, such as Vodafone or British Petroleum. As such, we would also need to compare apples to apples when comparing the returns. And wouldn’t you know it, smaller companies are just as risky whether in private or public hands, and commensurately also offer the same returns.

 

But what about the fees and the long lock ups? This is where it gets interesting, because investing in private companies takes time, to do research, negotiate and structure the transactions. And since financial professionals don’t come cheap, the fees and costs to invest in private equity are very high. Worse, we have to commit to paying fees for the duration of our investment, even if it goes wrong. We can only get out when the fund unwinds (and all the investments have been sold) or when another investor wants to buy in (but strangely that never happens when we all want to get out). 

 

Is there any value in private equity then? Yes, you do get rewarded for tying up your money and the current illiquidity premium is around 3% per year. Many would also argue that one can unlock value, by being able to influence the strategy of a company (in being an early stage and/or outsized investor). I would agree with that and there are people with great track-records of generating growth or turning companies around. But lest we forget, that companies are companies, businesses are businesses and they share many of the same risks - regardless of who owns them. As such, there are also limits to the degree of diversification one can achieve from owning private as well as public equities.

 

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