Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 301

Private equity grows as listed companies are only the tip of the iceberg

Private equity is not an asset class at the top of most individual investors’ wish lists. Why? It is certainly an asset class people are aware of. It gets a lot of press, and it is an asset class that large institutional investors value and allocate to. The Future Fund, for example, has a 15% allocation to private equity.

So why don’t individual investors invest significantly in this asset class? The overriding theme is that it is too hard to access. Reasons may include a lack of suitable investment vehicles which would enable investors to obtain meaningful and diversified access. The investment process is also complicated by minimum equity commitments, the management of progressive drawdowns, irregular distributions, and long-term lock ups.

What is private equity?

Private equity typically involves taking an ownership interest in an unlisted, private business or asset. It includes a broad range of longer-term and company-specific exposures which, because they are not listed on a public market, tend to exhibit somewhat lower correlation to traditional stock and bond markets. Private equity managers seek to generate superior returns through taking an active role in monitoring and advising companies through restructuring, refocusing and revitalising tactics in order to sell the investment at a profit. It is a more hands-on investment compared to an investment in the shares of a listed company.

It may surprise some that the universe of private companies is significantly larger than that of public companies, and that the number of listed companies has been steadily decreasing. As shown in the following diagrams, since 1996 the number of US listed companies has fallen 50%.

Source: S&P Capital IQ

Global allocations by investors to private equity have been steadily growing since 2000, having increased almost 6 times over the period.

How has private equity performed?

One of the key reasons for the increasing allocations to private equity may have been its performance. Private equity has outperformed public equity across long term time horizons (10 and 20 years) as well as geographic regions. The following graphs compare private equity investments against hypothetical funds that buy and sell shares of the relevant equity index at the same time the private equity vehicles call and distribute cash.

Source: GCM, using data from Burgiss Group and MSCI

There are a number of factors that have historically contributed to the strong performance of private versus public equity. The most significant are:

  • the lack of short-term public pressure allowing for a long-term investment orientation
  • the historical resilience of performance across various market environments
  • the illiquidity premium – investors prefer liquid investments and therefore demand an increased return on less liquid alternatives.

Five ways the risks are different from listed equity

The unlisted and hands-on nature of private equity investments suggest there are different risk considerations compared to public equity markets. Some risks are of course the same – economic, market, currency, political, etc. – but others differ, and we highlight these below:

  1. Unlisted private equity investments are typically illiquid. Private equity funds may hold securities or other assets in companies that are thinly traded or for which no market exists.
  2. Distributions tend to be irregular and depend on the sale of an underlying investment.
  3. Third party pricing information is also not available for a large proportion of private equity assets. Valuations may therefore require discretionary determinations and in certain circumstances investors may have to rely on valuations from the underlying managers themselves.
  4. The companies invested in may involve a high degree of business and financial risk. They may be in the early stage of development, may be rapidly changing, may require additional capital to support their operations, or may be in a weak financial condition. While these are also opportunities, they clearly represent risks that need to be controlled by private equity managers.
  5. There is also generally less information available about private companies than their listed peers. This means that investors with higher quality information are often able to make better investment decisions and is one of the reasons performance dispersion in private equity tends to be greater than in the public markets. Extensive due diligence and careful monitoring are essential safeguards when constructing private equity portfolios.

What does private equity bring to a diversified portfolio?

Historically, one of the key benefits of private equity has been its somewhat lower correlation to other traditional assets and the diversification benefits this has provided at a portfolio level. The chart below shows that adding a 20% allocation of private equity to a traditional 60/40 equities/bond portfolio generated higher returns with lower risk (as measured by volatility) over the last 20 years.

Source: GCM using data from Burgiss Group

To an extent, the diversification may be derived from periods of economic stress such as the GFC.

How can retail investors access private equity?

Private equity has been a difficult asset class to access for individual investors. However, there are now a handful of unlisted and listed funds and trusts in Australia that overcome many of the hurdles.

Listed and unlisted vehicles have their own pros and cons, but the key is liquidity. Unlisted funds may offer daily or monthly liquidity, however, given the illiquid nature of the underlying investments, they have the ability to restrict or freeze redemptions. Listed vehicles provide liquidity for investors who can buy and sell on market as long as an active market exists.

The private equity universe is vast, differentiated by types of companies, investment strategies, and implementation options. Private investment vehicles differ markedly across these variables and, as with listed equity vehicles, it makes sense to have more than one in your portfolio.

 

Nick Griffiths is the Chief Investment Officer of Pengana Capital. This article is for general purposes only and does not consider the circumstances of any investor.

RELATED ARTICLES

How individuals can build a private markets portfolio

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Overcoming the fear of running out of money in retirement

There’s an epidemic in Australia that has nothing to do with COVID-19, the flu, or the respiratory syncytial virus. This one is called FORO, or the fear of running out of money in retirement, and it's a growing problem.

Latest Updates

Investment strategies

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Economy

A pullback in Australian consumer spending could last years

Australian consumers have held up remarkably well amid rising interest rates and inflation. Yet, there are increasing signs that this is turning, and the weakness in consumer spending may last years, not months.

Investment strategies

The 9 most important things I've learned about investing over 40 years

The nine lessons include there is always a cycle, the crowd gets it wrong at extremes, what you pay for an investment matters a lot, markets don’t learn, and you need to know yourself to be a good investor.

Shares

Tax-loss selling creates opportunities in these 3 ASX stocks

It's that time of year when investors sell underperforming stocks at a loss to offset capital gains from profitable investments. This tax-loss selling is creating opportunities in three quality ASX stocks.

Economy

The global baby bust

Across the globe, leaders are concerned about the fallout from declining birth rates and shrinking populations. Australia, though attractive to migrants, mirrors global birth rate declines, and faces its own challenges.

Economy

Hidden card fees and why cash should make a comeback

Australians are paying almost two billion dollars in credit and debit card fees each year and the RBA wil now probe the whole payment system. What changes are needed to ensure the system is fair and transparent?

Investment strategies

Investment bonds should be considered for retirement planning

Many Australians neglect key retirement planning tools. Investment bonds are increasingly valuable as they facilitate intergenerational wealth transfer and offer strategic tax advantages, thereby enhancing financial security.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.