In this article, we unpack the key considerations in private equity (“PE”) investments and juxtapose them with traditional assets to help investors gain a better understanding of this asset class.

A PE Investor’s Considerations

1.    Risk Tolerance

Every investor’s risk profile is different. In PE, this dictates whether one leans towards high-risk, high-reward early-stage companies or the relative stability of established firms with steady cash flows. Understanding your risk appetite is key to shaping a PE strategy that fits your investment personality.

Compared to traditional investments such as stocks and bonds, PE typically involves higher risks due to its illiquid nature and longer investment horizons.

2.    Time Horizon 

PE is a long game, requiring investors to commit capital for extended periods.  PE investments are illiquid and cannot be easily sold or transferred.

In contrast, public market investments offer shorter time horizons. Stocks are highly liquid, allowing investors to buy and sell shares within the same trading day. Bonds, depending on their type and maturity date, can offer medium-term investment horizons for investors who buy and hold to maturity.

3.    Capital Commitment

Understanding the concept of a capital call is essential in PE investing, where funds operate on a capital call basis. This means that investors commit a certain amount of money to the fund, but this capital is not invested immediately into the fund. Instead, the fund managers call for portions of these commitments as investment opportunities arise over time. The timing and amount of each capital call is determined by the fund's strategy and market conditions. For investors, this necessitates careful cash flow management to ensure that sufficient liquid assets are available to meet these calls when they occur.

4.    Liquidity 

The liquidity risk in PE refers to the difficulty of quickly converting an investment into cash. Unlike publicly traded stocks or bonds, PE investments are in companies that do not have publicly traded shares available on stock exchanges. This absence of a public market means there is no easy mechanism for buying and selling these investments, contributing to their illiquidity. While there is a secondary market for PE interests, selling these stakes via this channel may require significant discounts to their perceived value, and finding a buyer can be challenging and time-consuming.

5.    Capital Risk

As with any investment, there is a potential for loss on your invested funds. PE investments are also directly impacted by the operational performance of the underlying portfolio companies, which can vary widely and be affected by factors such as management performance, competitive pressures and market demand for their products or services. Additionally, the broader economic and financial environment can reduce the value of investments. Given these dynamics, investors face the risk that their capital may not only fail to generate the expected returns but also suffer losses if the underlying portfolio companies do not perform as anticipated.

Wrapping It Up

Embarking on the journey of PE investing involves a deep dive into your financial aspirations, risk appetite and long-term goals. It is essential to enter the PE space with a clear understanding of its complexities and a strategy aligned with one's investment goals and constraints. By doing so, investors can leverage PE’s potential rewards while managing the inherent risks. Like any investment, due diligence, professional advice and a balanced perspective are key to making informed decisions that resonate with your broader financial goals.

Private equity (“PE”) is a well-established part of the portfolios of many institutional investors and increasingly, it is also being allocated to the portfolios of accredited investors. We examine two main reasons why investors add PE to their portfolios.

Why Do Investors Turn To PE?

1.    Historical Performance vs Public Markets

Exhibit 1

The allure of PE is rooted in its historical performance, which showcases a consistent potential for high returns. According to data from investment data company, Preqin, global PE funds have generated higher returns compared to the public-market equivalent MSCI World Index, which tracks the performance of developed market stocks (Exhibit 1). Industry data has continually demonstrated that PE outstrips public equity markets over extended investment periods. The outperformance of private equity over public equity stems from the active management approach of PE managers, which capitalises on their industry acumen to enhance the value of their holdings. PE investments come with their own set of risks as investing in PE can be unpredictable in terms of cash flow, and PE is also illiquid in nature and investors may face long lockup periods.  

2.    Diversification

Diversification is a foundational principle of investing, and PE could be an attractive addition to an investor's portfolio. By nature, PE investments are not directly correlated with the fluctuations of the stock or bond markets. Also, PE presents opportunities across a variety of sectors, stages of business development and geographic regions, offering a breadth of exposure that is difficult to replicate in public markets. From tech startups in Silicon Valley to manufacturing firms in emerging economies, PE taps into a diverse array of growth stories, further enhancing the diversification and potential resilience of an investment portfolio.

How Is The Private Equity Industry Trending? 

The global PE industry has experienced remarkable growth over the last two decades, culminating in a record-breaking 2021. This peak was driven by a robust fundraising environment, in which PE fund managers were successful in raising a historical high of USD 1 trillion in 2021 (Exhibit 2). Deal activity surged, particularly as fund managers capitalised on favourable market conditions to liquidate mature investments. 

Exhibit 2

However, the upward trajectory in fundraising altered with the Federal Reserve’s decision to raise interest rates in June 2022. These rate hikes typically lead a cooling-off period for investments as borrowing costs rise and investors become more cautious. The reverberations were felt across the PE industry, with noticeable contractions in amount of capital raised (Exhibit 2). As we progressed into 2023, the global economic landscape, faced with a slowdown in growth, inflationary pressures and geopolitical uncertainties, continued to impact the PE sector. Investors, now more risk-averse, scaled back their activities, leading to a downturn in both the number and value of PE deals (Exhibit 3).

Exhibit 3

Despite the recent activity declines, the PE industry is expected to navigate these challenges effectively as it did with previous economic shifts, and continue to evolve and innovate.

In our next article, we will delve into the Risks and Considerations of PE Investing, providing insights into key factors one should be aware of when assessing PE investment opportunities.

Our ongoing research on the industry’s dynamics and performance has revealed several insights, including the following trends:

Macroeconomic challenges continued. If 2022 was a tale of two halves, with robust fundraising and deal activity in the first six months followed by a slowdown in the second half, then 2023 might be considered a tale of one whole. Macroeconomic headwinds persisted throughout the year, with rising financing costs and an uncertain growth outlook taking a toll on private markets. Full-year fundraising continued to decline from 2021’s lofty peak, weighed down by the “denominator effect” that persisted

in part due to a less active deal market. Managers largely held onto assets to avoid selling in a lower-multiple environment, fueling an activity-dampening cycle in which distribution-starved limited partners (LPs) reined in new commitments.

Performance in most private asset classes remained below historical averages for a second consecutive year. Decade-long tailwinds from low and falling interest rates and consistently expanding multiples seem to be things of the past. As private market managers look to boost performance in this new era of investing, a deeper focus on revenue growth and margin expansion will be needed now more than ever.

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