The private equity asset class continues to grow in size and influence as investors seek alternative sources of return and a greater diversification of risk. At the same time, operating companies continue to seek diverse sources of capital. Private equity is becoming more accessible to investors and expanding investors’ exposure to a wide range of deal types.
But is private equity suitable for all investors? The BDO investment team shares its perspectives on the private equity asset class, including its merits, risks, and spectrum of opportunities.
How do you define private equity as an asset class?
Private equity refers to investing in a company that does not have a publicly listed security. The asset class comprises a spectrum of investment opportunities, from startups needing seed capital to mature, cash flow-producing companies. BDO Wealth has historically tended to focus on strategies with a growth focus involving viable businesses with an existing customer base, meaningful revenue, and either existing EBITDA or a clear path to profitability. Typically, these companies may have faster top-line growth and, eventually, bottom-line growth than your average company. There are a wide spectrum of private equity strategies and BDO Wealth is always seeking attractive new opportunities.
BDO Wealth can advise clients who wish to invest in private equity opportunities through buyout funds and the secondary market—both traditional secondaries and secondaries led by general partners (GPs).
What is the secondary market?
A traditional secondary is where an investor in a fund—a limited partner (LP)— wants to cash out of a position before the end of the contractual term. The LP finds a qualified buyer to replace them. Increasingly, we are seeing GP-led secondaries, where the general partner—the private equity firm managing the fund—finds new sources of liquidity. This often occurs when a fund is more advanced in its life, and the fund manager wants to stay invested in the portfolio companies.
Private equity secondaries have become a large, specialized business. According to Private Funds CFO, secondary funds accounted for 15% of total PE funds raised in 2020.[1]
What are private equity co-investments?
Sometimes, a private equity fund manager wants to make a larger investment in a portfolio company but is restricted by the fund’s legal structure, does not want further capital exposure, and/or does not want to share the deal with a competing private equity firm. In this situation, a co-investment may make sense. The manager arranges for an investor—such as an existing LP in the fund—to make a direct investment in the portfolio company outside the structure of the existing fund.
Co-investing is another area of strong growth in private equity. Co-investors are friendly sources of capital. The advantage to the investor is that they generally pay a smaller fee (or none at all) and obtain a direct equity stake in the portfolio company.
What are some key benefits and risks of private equity for investors?
One key argument for private equity is that investors can benefit from the so-called “illiquidity premium.” Private equity investors are expected to receive a higher return than public markets in exchange for making an illiquid investment. Essentially, the strategy often entails taking a portfolio company that may not be ready for the public markets, adding a professional management team that can help it grow and improve margins, and getting it ready to go public or be acquired. The goal is to exit at a higher multiple vs. where you entered.
Public markets are shrinking while the number of private companies grows. Companies are staying private longer, so the bulk of an investor’s return could come while the company is still private rather than after it goes public. The private equity market offers a widening spectrum of opportunities to deploy capital for investors.
The key risks of private equity also include illiquidity and an investor’s hold period. These are typically long-term positions that investors hold for 10 years or more in some cases. An investor’s capital is tied up for an extended period with limited liquidity since the PE firms determine when capital calls and distributions are made. Investors need to account for this long hold period in their overall portfolio approach. It’s also worth noting that the underlying investments, because they are not publicly traded, do not have oversight of their financial statements from the SEC in the same way as a public company investment in a pooled investment vehicle offered by a registered investment company.