Innovations in Private Markets
This blog is part of a series that highlights insights from my upcoming book Goals-Based Investing.
“It’s clear to me when you do private equity well, you’re making companies more efficient and helping them grow and become more profitable. That success means our investors—such as public pension funds—benefit, which contributes to the economic wealth of society.”
- David Rubenstein Co-founder, the Carlyle Group
Private markets have historically been the exclusive domain of large institutions and family offices, due to accreditations standards, high minimums, and limited liquidity. Private markets include private equity, private credit, and real assets; but for the purposes of this blog, I will primarily focus on private equity.
In recent years, through product innovation[i], and the willingness of private equity managers to bring accredited investor products to the market, these once elusive investments are now available to a broader group of investors. There has been a growing demand for private equity based on their attractive absolute and relative returns. Private equity has historically delivered a 300-400 basis point illiquidity premium relative to traditional equity indexes.
What is the appeal of private equity?
Private equity’s appeal is the opportunity to invest in early-stage companies and reap the benefits as companies go public, or benefit from a private equity manager restructuring a troubled company. Early investors in Google, Apple, and Facebook received oversized returns when the companies went public via an IPO.
Private equity represents a range of opportunities across various stages of development. On one end of the spectrum, we find venture capital: early-stage companies that are still developing their product or service. At the other end of the spectrum, we find buyout: cash-flow-positive companies that may benefit from reorganizing or selling certain assets.
Depending on a company’s developmental stage, private equity managers can help in different ways, from launching new products and services, to spinning off non-core businesses or making strategic acquisitions. They can drive value creation by adding leadership, expanding a company’s geographic footprint, negotiating favorable terms, and spending on marketing. Private equity managers can add value through bolt-on transactions or by consolidating businesses
Venture companies are at an early stage of an idea for a unique product, service, or technology. Early-stage venture may have little to no revenue and needs capital to bring its ideas to life. Founders often seek capital to fund their business plans. Google, Facebook, and Uber began as fledgling companies with ideas that would change the market. They needed capital early on to fund those ideas. When they ultimately went public, they made substantial money for their founders and early investors.
Growth companies have a proven business model, are growing rapidly, and are either profitable or have a clear path to profitability, with revenues growing 20 percent or more annually. Private equity firms typically take a minority stake in the company and work with the management team to help create value through operational improvements and revenue growth, either organic or through acquisition.
Buyout companies have stable revenues and cash flow. A private equity fund purchases firms at this stage through a leveraged buyout and executes a long-term value creation plan, which may involve organic growth, inorganic growth, and operational improvements, before selling the company. These represent the largest segment of private capital.
Value Creation
Private companies have the luxury of planning for the long run. Public companies often suffer from a short-term perspective, struggling to meet quarterly earnings expectations. In a Wall Street Journal op-ed, Warren Buffet and Jamie Dimon noted that, “Companies frequently hold back on technology spending, hiring, and research and development to meet quarterly earnings forecasts that may be affected by factors outside the company’s control, such as commodity-price fluctuations, stock-market volatility and even the weather.”
By contrast, private companies can focus on executing long-term strategies without having to appease shareholders. The results show that this freedom is a substantial benefit. Private equity managers focus on creating value over three to six years. They often bring operating expertise and can help founders develop and implement a multiyear plan, which often leads to stronger growth than public companies enjoy.
Private companies also benefit from an information advantage. Public companies are required to disclose financial information and key business drivers to shareholders. Most public companies are also widely scrutinized by Wall Street research, so all information is priced into the stock price.
Conversely, the private markets are inefficient, and skilled private equity managers can exploit their informational advantage to identify attractive acquisitions. Once an acquisition happens, private equity managers can focus on executing their long-term strategy without the distraction of public scrutiny.
Although we often focus on the value of infusing financial capital into a young or struggling company, there is also tremendous value in adding human capital: seasoned managers who have operating experience, industry knowledge, and vast networks. Private equity firms can leverage their network of operating talent to help execute a company’s plan.
Product Innovation
As previously mentioned, the primary users of private equity were initially institutions and family offices, that had significant capital that could be tied up for an extended period-of-time. But as more high-net-worth investors began to demand access to private equity, the structures needed to evolve to meet the needs of this important segment.
Product innovation has sought to address some of the limitations of the classic private equity structure: minimums, tax reporting, and liquidity among others. Feeder funds, interval funds, and tender offer funds have helped democratize private market investing and address some of the structural limitations.
Classic LP funds are available only to qualified purchasers, at higher minimums and limited liquidity. Because these investments are structured as limited partnerships, investors receive K-1 tax reporting, which is often delayed and may be prone to restatements. Investors commit capital that is drawn down over time (capital calls).
Feeder funds have become popular with HNW investors because they let investors pool capital and access top-tier funds at lower minimums. The feeder fund gives general partners scale and efficiency. Feeder funds are available to qualified participants, who are then subject to capital calls. There is no cash drag because feeder funds aren’t required to meet short-term liquidity demands.
Interval funds are available to accredited investors, or even to those with lower accreditation, at lower minimums and quarterly liquidity. Interval funds typically invest in private credit. They are not subject to capital calls and provide reporting via 1099 forms. To meet liquidity demands, interval funds may experience cash drag: the cost of being liquid enough to meet redemption requirements.
Tender Offer funds are available to accredited investors at lower minimums, with liquidity via a tender offer. The board decides how much liquidity they’ll provide and when. Tender offer funds typically hold private equity. They are not subject to capital calls and provide 1099 tax reporting. Tender offer funds are not required to hold liquid assets.
Before investing in private equity, advisors and investors must understand the various stages of development and the corresponding associated risk, from venture capital through growth to buyout opportunities. As private equity has become more available to a larger group of investors, advisors need to get up to speed about product innovation and the options available to their clients.
Wealth advisors should take the lead in educating investors about the merits of private markets, and address some of the fundamental questions before allocating capital. “What role do these strategies play in a client portfolio?”, “How can I evaluate the various private market options?”, “How much should I allocate to private markets?”, and “where should I source the allocation?”
[1] Davidow, Anthony, “Private Equity: Innovation and Evolution”, Investments & Wealth Monitor, November-December 2019