Getting to grips with private equity

Private equity: the basics

Private equity (PE) is commonly described as an equity or equity-related investment into a company that is not publicly listed. PE can be accessed by direct investment into private companies or indirectly through fund exposure.

Long-term investment

Since capital flowing into PE funds tends to be committed for several years, PE is considered a long-term asset with typical fund terms of around 10 years. The cash flow cycle of the fund is characterised by negative cash flows (the so-called J-curve) during the investment period (which is usually three to five years) where capital is committed into companies.

Fund managers will seek to add value to the underlying company, via operational improvements, international expansion and mergers or acquisitions over a four to six-year period.

Once the business plans have been executed, the company will be exited. The exit could be achieved through a listing on the public markets, private sale to larger corporates or even to other PE funds with different investment criteria. After the exit has been made, the proceeds will be repaid to the investors.

There are several types of PE investments which target different stages of a company lifecycle and also different sizes of company. Venture capital is deployed in the early days of a company from initial idea through to revenue generation. Growth investment targets the next phase, as a company becomes well-established; while buyout investment occurs in more mature firms. Within buyout, companies range from small cap (minimum $50-$100m company size) through to mega cap ($5bn+). This gives investors a wide selection of investment opportunities alongside diversification benefits.

Investment rationale

The fundamental reason to invest into PE is the potential to enhance returns significantly compared to more traditional investments. While PE and equity markets tend to have a high correlation, studies show that over 10 years PE has historically outperformed global equities by 4%. Another positive of PE includes its low correlation to other traditional investments (sovereign bonds, investment grade credit and commodities) which offers important diversification benefits in a multi-asset portfolio.

Key risks

Some key risks to consider for PE are an investment in a “blind pool”, where it is not known at the outset which companies the fund will invest in, the length of time capital will be committed before being deployed and the time-span required to generate positive returns for investors, following an initial period of negative returns.

It is for these reasons that we believe these risks can be mitigated through secondary funds, as mentioned in the May issue of “Market Perspectives”. The secondaries market has been growing at a rapid rate of 25% annually since 2010 with $74bn traded in 2018 and about $90-120bn expected to be traded within five years offering a wide range of buyers, sellers and assets alike. The market has historically been resilient across economic cycles, with lower return volatility compared to other PE asset classes, such as venture capital and buyouts.

Important factors worth noting with secondary funds are that:

1. They invest in funds after the initial investments are made (around years 4-7), when portfolios are already significantly funded and generating liquidity. Therefore, the element of blind pool investing is less prevalent, as most of the capital has already been called and invested.
2. By entering in at the later stages, the J-curve is likely to be mitigated and so a return on investment would likely happen over a shorter time horizon, as companies are closer to an exit process.
3. Due to the above two points, secondary investments have a lower multiple of invested capital versus investing in a fund from year one. However, the shorter investment holding periods ensure a comparable internal rate of return.

Enhanced risk-adjusted returns

Although the risk involved remains higher compared to more traditional asset classes, due to PE’s long-term horizon and illiquidity, PE offers an enhanced risk-return profile which is especially attractive in the current low-rate environment. Recent studies reported that allocating a high percentage of a portfolio to PE generates larger returns than portfolios with minimal allocations.

Specifically, on a 20-year horizon, investors with more than 15% exposure to PE have been rewarded with a median annualised return of 8.1%. This, along with the immediate diversification benefits, provides a strong case for considering secondary investments core to an investor’s private market portfolio.

Deciding what suits

Investors should assess carefully what types of PE investments suit them better, based on their liquidity needs, risk profile and expected returns. In general, we recommend exposure to PE via secondary funds to capture the illiquidity and complexity premium available in private markets, while mitigating some of the risks and ensuring high levels of diversification.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This document has been issued by the Investments division at Barclays Private Banking and Overseas Services (“PBOS”) division and is not a product of the Barclays Research department. Any views expressed may differ from those of Barclays Research. All opinions and estimates included in this document constitute our judgment as of the date of the document and may be subject to change without notice. No representation is made as to the accuracy of the assumptions made within, or completeness of, any modeling, scenario analysis or back-testing.

Barclays is not responsible for information stated to be obtained or derived from third party sources or statistical services, and we do not guarantee the information’s accuracy which may be incomplete or condensed.

This document has been prepared for information purposes only and does not constitute a prospectus, an offer, invitation or solicitation to buy or sell securities and is not intended to provide the sole basis for any evaluation of the securities or any other instrument, which may be discussed in it.

Any offer or entry into any transaction requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding transaction documents. Any past or simulated past performance including back-testing, modeling or scenario analysis contained herein does not predict and is no indication as to future performance. The value of any investment may also fluctuate as a result of market changes.

The value of any investment may also fluctuate as a result of market changes.

Neither Barclays, its affiliates nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation.

This document and the information contained herein may only be distributed and published in jurisdictions in which such distribution and publication is permitted.  You may not distribute this document, in whole or part, without our prior, express written permission. Law or regulation in certain countries may restrict the manner of distribution of this document and persons who come into possession of this document are required to inform themselves of and observe such restrictions.

The contents herein do not constitute investment, legal, tax, accounting or other advice. You should consider your own financial situation, objectives and needs, and conduct your own independent investigation and assessment of the contents of this document, including obtaining investment, legal, tax, accounting and such other advice as you consider necessary or appropriate, before making any investment or other decision.

THIS COMMUNICATION IS PROVIDED FOR INFORMATION PURPOSES ONLY AND IT IS SUBJECT TO CHANGE. IT IS INDICATIVE ONLY AND IS NOT BINDING.