Private equity: Attractive opportunities for private investors away from the stock exchange
Private equity funds are a great way to invest in attractive companies away from the stock market using only a small amount of capital. These alternative investments play an increasingly important role in terms of stabilizing and diversifying portfolios – particularly in the current environment of low interest rates and low returns. How does private equity work, and how can private individuals invest in it?
Investing in private equity can pay off
Apple, Google, Facebook, Microsoft, and Amazon – the world's largest companies – have one thing in common: They chose the IPO route. However, a large part of the economy comprises small and medium-sized companies that are not listed on the stock exchange. Private equity enables these companies to raise capital.
Private equity therefore represents a huge market in Switzerland as well as globally – one that also offers major potential for private investors. A glance across the pond shows that private equity can be a lucrative means of diversifying a portfolio. University endowments such as those of Stanford and Yale have major exposure to private equity, giving them average rates of return of between 10% and 11% annually over the long term.
Private equity on the rise in Switzerland
Publicly traded companies comprise just a small portion of the Swiss economy. That makes it all the more surprising to find that many investors – particularly institutional ones – are not invested in private equity. Nevertheless, the number of private equity firms in Switzerland is on the increase. According to research company Preqin, the assets under management of private equity managers domiciled in Switzerland have multiplied more than sixfold since 2008.
How private investors can invest in private equity
Private equity was for a long time reserved for larger institutional investors, as it required an initial investment of many millions of Swiss francs. Now, however, there are also private equity funds that pool capital from investors and invest in a single company or portfolio of several companies.
Another possibility is to purchase private equity funds of funds, or alternatively shares in private equity companies that are in turn listed on the stock exchange. Private investors can diversify their portfolio by investing in private equity and thus improve their risk-return ratio.
Value added by private equity funds
A look at the primary characteristics of private equity highlights the ways in which this asset class differs from publicly listed equity investments, and what added value it provides in terms of portfolio diversification and risk/return profile:
- Potential long-term outperformance: The long-term returns on private equity are often higher than those on publicly listed securities. The outperformance in US dollars over the last ten years was between 4% and 7% annually.
- Active influence: Private equity managers can actively influence the portfolio companies and contribute their specialist expertise and networks.
- Illiquidity premium: Private equity managers hold investments in portfolio companies over the course of several years and help them implement strategic initiatives.
- Less volatility: Rather than being linked to short-term market fluctuations, the valuation of a private equity investment is driven by the operational progress of portfolio companies.
- Expanded investment universe: A majority of companies are not listed on the stock exchange. Innovative companies that develop disruptive technologies in particular are often in private hands.
Risks when investing in private equity funds
A private equity portfolio poses challenges and risks for an investor:
- Financial risks: Investments in private equity funds generally involve a significant degree of financial and/or business risk. Companies or funds may be highly leveraged and therefore may be more sensitive to financial developments or economic factors.
- Illiquidity: Investors need to be liquid, since there is no established secondary market. Investors should be prepared to keep the investment until maturity and wind-down of the underlying private equity fund. Investments are usually not tradable, or are of limited transferability between investors.
- Long-term investment horizon: The time horizon for private equity investments can be ten years or more. It can take a long time until a private company becomes established. Therefore, private equity investments usually need more time until they generate a profit.
Companies likewise benefit from private equity
Although the time horizon can be ten or more years, the first dividends are generally paid to investors from the profits generated after just a few years. This allows private investors to benefit from private equity too.
Private equity companies often hold a majority interest, meaning financial backers can influence corporate strategy – up to and including a complete takeover of the company. In many cases, however, companies get back on the growth track and/or improve their market position under the leadership of private equity companies.
As venture capital, private equity can also be used to finance newly created startups.