Private equity – an asset class with potential
Investments in unlisted securities have increasingly moved onto investors' radars in recent years. What's more, against a backdrop of persistently low interest rates, high security prices across the board, as well as attractive historical returns, this asset class is likely to keep the wind in its sails.
Reasons for investing in private equity
In their hunt for returns and investment diversification, investors are increasingly turning their attention to private equity. This asset class has historically produced strong returns, with various studies also highlighting its outperformance versus public markets. The reasons for the outperformance are manifold. When private equity was in its infancy, the main focus was on the use of leverage; today, however, managers are generally looking for operational improvements within the company and have a clear value creation plan for every investment made.
One of the structural drivers behind this asset class is the increasingly broad investment universe. The number of private companies has grown rapidly in recent years, in contrast with a decline in the number of listed companies. Companies are staying in private hands for longer and deciding to float on the stock market at a later point in their life cycle. This is partly due to the flexibility enjoyed by companies that are not in the public markets, but also to the sharp increase in financing opportunities seen in recent years thanks to private equity funds. This trend is leading to a situation where equity market investors are only able to participate in the value generation of these companies at a later stage. Through exposure to private equity funds, investors are able to participate in the strong growth of private companies.
However, the excess returns generated by private equity come at a price: Investors must be prepared to live without the liquidity available on public markets. The life of a traditional private equity fund is typically ten years. Secondary funds, which have experienced strong growth in recent years, increasingly represent an attractive source of liquidity for private equity investors and managers. From an investor perspective, too, secondary funds are enjoying increased popularity owing to their flatter "J-curve" and broad diversification.
Private equity in a portfolio context
Traditionally the preserve of large-scale investors such as pension funds and insurers, this asset class has transformed itself in recent years and is now increasingly accessible to non-institutional investors, too. Given the complexity of private equity, investors should nevertheless familiarize themselves in detail with the mechanisms behind these investments and the way they work.
In contrast to public markets, private equity is subject to a different range of return drivers; this means it can have a diversifying effect within traditional portfolios and lead to an improvement in the portfolio efficiency curve. Unlike other alternative investments such as hedge funds and real estate, which are mainly used to reduce portfolio volatility, the addition of private equity results in enhanced risk-adjusted return expectations. However, the investor should bear in mind that within this asset class there is a broad spread between the returns achieved by the best and worst managers. An extensive network, rigorous due diligence, as well as access to the most successful private equity houses are therefore key success factors for investing in private equity.
Constructing a private equity portfolio
The weighting of a private equity allocation within the portfolio depends on the investor's risk tolerance, return expectations, and liquidity profile. When constructing a private equity portfolio, we recommend broad diversification across six dimensions: instrument, manager, strategy, geography, sector, and vintage. This broad diversification across different dimensions aims to optimize the risk/return profile over various economic cycles.
A core-satellite approach can be helpful when constructing a portfolio. A core solution with broad diversification is designed to generate a predictable basic return, whereas satellites contribute to outperformance. These niche strategies are generally geared toward a specific theme and exhibit a differentiated cash flow profile.
Outlook for private equity
The general trend towards innovative solutions is increasingly evident in the case of private equity, too. Alternatives to the standard fund model, such as co-investments and long-term funds, are on the rise and enable investors to structure their exposure to the asset class in a more flexible way.
The allocation to private equity has increased sharply in recent years and private equity managers have generated strong capital inflows. The "dry powder" level (committed but unallocated capital) stands at a record high and valuations have also soared. Due to the broad universe of private companies and clearly differentiated potential for value creation among the top managers, this asset class is nevertheless likely to go on offering attractive opportunities for investors. However, broad diversification and access to the best managers are essential.