What Is Private Equity?
The private equity world is a mystery to most investors. Here we explain what private equity is and reveal how investors can get in on the action.
Private equity refers to an asset class consisting of investments in companies that are not publicly traded or listed on a stock exchange. Private equity investors are usually large institutional firms and high net worth individuals who have a particular interest, and great passion, in that specific field.
Private equity firms, venture capitalists, and wealthy individuals invest for entirely different reasons, and usually have their own goals, preferences and investment tactics. However, the one defining attribute that they all have in common is to provide working capital to their target company. It’s this capital that encourages expansion, new product development, and sometimes but not always, the restructuring of the company’s operations, management, and ownership. The aim of private equity investment is to boost the target company’s profitability and value, and then ultimately to sell it around five to ten years down the road to reap a substantial return on investment (ROI).
The target companies – which tend to be relatively mature, established businesses across a range of industries – usually require quite high investment minimums. Minimums can start as low as US$100,000, but more often run to the tens of millions of dollars. That unfortunately rules out 99% of the average investor market, which is why private equity such a niche market. But if you are in a position to invest, the returns can be extremely high.
An extraordinary early example of this was in 1982 when William Simon (then US Secretary of State) gathered a group of investors together to acquire Gibson Greetings, a maker of greeting cards, for US$80 million. The investors themselves contributed only US$1 million (and borrowed the additional US$79 million). In 1983, just sixteen months after the deal, Gibson completed a US$290 million initial public offering (IPO) and Simon and his investors pocketed roughly US$66 million.
Over the last ten years, private equity investment has shown an average annual return of over 11%. In fact, a 30-year comparison of US private equity against the S&P 500 shows that the average US-based private equity fund outperforms the S&P 500 by 6.2% per annum. And, and this is quite important, with less than two thirds of the volatility. It’s just another reason why this sector is so attractive to investors. When you don’t have to sit and worry about the ups and down of the market on a daily basis, the stress is somewhat reduced.
Another good early example of private equity investment was Georges Doriot, who along with Ralph Flanders and Karl Compton formed ARDC, or the American Research and Development Corporation. The aim of the company was to encourage private sector investment in businesses run by soldiers returning from World War II. Their first private equity investment in 1957 was to raise US$70,000, mainly from wealthy families that they knew, to buy Digital Equipment Corporation. When the company went public in 1968 it was valued at US$38 million, representing a return of over 500 times its original investment. Gains like these are not unusual in the private equity arena.
WAYS TO INVEST
99% of ordinary investors can’t afford to invest in private equity start-ups, so how do you get a foot in the door of this ever so exclusive club?
The easiest way to invest in private equity is to invest in a company that invests in private equity on behalf of others. These companies make their money in the form of fees and profit shares that come from the myriad of funds that they have under management. KKR & Co and The Blackstone Group are probably two of the best options, and by buying their shares you gain access to their private equity investing.
You can also invest in companies that invest their own capital in private equity. Berkshire Hathaway is a prime example of a company that does this very well, and – although rooted in the insurance business – it has wings run by Buffett that invest in stock and private companies. Berkshire also owns a chunky portfolio of private equity investments that includes the Kraft-Heinz Co and Nebraska Furniture Mart.
An investment of US$1,000 in Berkshire’s class A shares at US$19 per share in 1964 would have given you 52 shares. At the close of business on October 16th 2017 those 52 shares would now be worth US$14,604,200.
Last but by no means least you can invest in firms that invest in equity and debt financing to do deals. Prospect Capital Corp (PPC) is a good example of this type of company, and as a business development company they enjoy certain tax benefits as long as they follow specific accounting rules. As an equity investment, it’s quite attractive, and currently PCC has a dividend yield of 13.8%, with US$7.2 billion in assets under management (AUM).
THE BOTTOM LINE
Do your research! Warren Buffett of Berkshire Hathaway does this very well, and even calls target companies to talk to the people on the ground to get a feeling for what their own employees think about the company. He’ll talk to line managers and receptionists, sometimes before talking to members of the board of directors. It’s this inside knowledge that gives him a certain edge.
Private equity investing isn’t the same as buying shares though, and you have to make sure that you understand the firms’ strategies and tactics, how they position themselves in the market, and how they will be a success in the future. In the end if you like what you have found then you have most probably found the company that is right for you to invest in.