Why Invest in Private Equity?
Preface
Over the course of a few decades, private equity has emerged as a powerful force reshaping the global financial landscape. Originating in the early 20th century as small, specialized firms focused on venture capital and leveraged buyouts, the industry has since grown into a complex and far-reaching ecosystem that touches nearly every sector of the economy. Today, private equity firms manage trillions of dollars in assets, wielding substantial influence over the fate of businesses, industries, and even national economies.
The growth of the private equity industry has been driven by institutional investors: asset owners and allocators who have increasingly turned to private equity—including buyouts, growth equity, and venture capital—as a key component of their investment strategies. But why have these investors favored private equity so heavily?
The past 15 years have undoubtedly been a favorable period for the asset class, with lower interest rates providing a greater margin of safety for underlying investments and increasing the likelihood of success. However, this does not fully account for the industry's expansion, which began to gain momentum as far back as the 1960s. What follows are some of the insights I have gathered so far. This is an initial attempt, and it is by no means exhaustive; I will continue to refine and expand upon these ideas as I continue to learn.
This is the first piece of a three part series: 1) Why Invest in Private Equity?
Return Objectives
The majority of foundations, endowments, and other "spending institutions" are set up as perpetual pools of capital with the goal of funding charitable causes, grants, and other philanthropic activities through distributions. To achieve this, these organizations must invest their assets in a way that offsets the impact of spending and inflation, aiming for a target return rate that ensures the assets continue to grow indefinitely. Depending on the specific type of organization, the IRS imposes different rules and regulations requiring a certain level of spending. For example, private foundations (such as the one that I work at today) are mandated to distribute at least 5% of their assets annually, as per IRC Section 4942. However, endowments differ in that they may have discretionary spending rates to fill any gaps in their institutions' annual budgets instead of a IRS mandated distribution requirement.
In practice, many foundations aim for a rate of return that not only covers required distributions, but also preserves the purchasing power of their assets. This often results in a target return of ~8% to ensure sustainability over the long term. The following is an illustrative equation that highlights the factors that are typically used to get to a ~8% return target:
Equity-Oriented Strategic Asset Allocation
To achieve a return objective—whether it is ~8% or higher—an institution's portfolio must have a heavy orientation towards equities, which means owning portions of businesses that are either publicly traded or privately owned. This approach allows exposure to global economic growth, development, and innovation. While publicly traded businesses are easily bought and owned, privately owned businesses are typically owned through investment partnerships.
Why investment partnerships instead of directly?
When institutions seek to invest in private companies, they typically do so in one of two ways: (1) by investing directly in companies, or (2) by investing through fund partnerships managed by third-party investment firms. Generally, investing in private equity funds and participating in co-investments is the most suitable approach to accessing private equity for two key reasons: (1) IRS limitations on private foundations owning operating businesses, and (2) the lack of sufficient scale to build a diversified and high-quality portfolio if an investor were to invest directly in private companies.
Private Equity-Oriented Equity Allocation
Private equity (including buyout, growth, and venture capital) is expected to continue generating higher net returns compared to other asset classes, including public equities. This makes it a key factor in achieving the required long-term return objectives. The reasons for this can be attributed to two major factors: (1) the small-cap effect and (2) the extensive opportunity set available in private companies.
1. Small Cap Effect
Private companies owned by private equity firms are generally smaller than publicly traded companies. These smaller, privately held businesses often have lower valuations, higher growth potential, more opportunities for improvement in areas such as operations/competitive positioning, and higher potential returns than larger businesses. While the small-cap effect was once prevalent in public markets, I believe it has largely shifted to private markets. For more on this, see my piece titled “Where Have All the US Public Companies Gone?”.
2. Private Company Opportunity Set
Within North America, the investment opportunity set in the private market is three to five times larger than that of the public market when measured by the number of companies. Currently, there are approximately 5,000 public companies with more than $25 million in revenue that trade on North American equity exchanges or operate in North America—and only about 3,500 of these have revenues exceeding $100 million. In contrast, there are over 22,000 private companies with more than $15 million in reported revenue and headquarters located in North America, including around 9,000 companies with reported revenues exceeding $100 million. The substantial direct and indirect costs of being public are prompting companies to either (a) remain private for longer periods or (b) choose to operate as private companies with support from private equity.
Structural Advantage? Impact of Volatility and Reduced Liquidity
Private equity firms typically update the valuations of their holdings on a quarterly basis, compared to publicly traded companies, which have daily price fluctuations. This valuation latency in private markets causes the volatility of values within private markets to be less than in public markets. The effect of reduced volatility is a “smoothing out” of portfolio values over time when private equity is included as part of the portfolio. However, private equity is also illiquid, and provisions must be made to ensure short-term liquidity if near-term giving or spending is required or anticipated.