Private Equity Investments.

Private equity is a distinct asset class that provides investors with the potential for high risk-adjusted returns and diversification benefits compared to public equity holdings. This is primarily due to the specific investment focus of venture capital, growth equity, and buyout equity strategies. Unlike other private asset classes such as unlisted infrastructure projects, private equity investors can use public equity market indexes to assess the relative risk and return of these investments.

Investors often seek diversification within private equity strategies by allocating investments across different vintage years and various investment managers. This diversification benefit is a result of private equity investments providing exposure to specialized areas of the economy. For instance, early-stage venture capital targets are typically in new industries or have disruptive business models with an expected rapid growth trajectory. This growth is often driven more by technological change rather than macroeconomic conditions. For example, a venture capital firm might invest in a tech startup developing a revolutionary AI technology, expecting it to disrupt the market and grow rapidly.

Similarly, growth equity investors aim for above-trend profitable expansion by gaining market share or entering new markets. Buyout equity, on the other hand, uses a controlling stake to drive a firm’s relative performance improvement versus its peers. However, it’s important to note that aggregate private equity returns are unlikely to diverge too far from those of public equity.

Private equity returns can diverge from public markets under normal market conditions, particularly if the entry involves a take-private transaction and they exit an initial public offering (IPO). However, in the case of a public market downturn, private equity markets face similar effects of adverse market conditions, which tends to increase correlation between public and private markets. For example, greater risk aversion among investors generally leads to a reduction in venture capital activity and the value of startups, while higher interest rates dampen buyout activity due to the higher cost of financial leverage.

Private equity investments, which include venture capital (VC), growth, and buyout equity, are associated with high expected returns that are less correlated. However, these investments also come with higher risks and costs. The risks include liquidity risk, valuation risk, agency risk, extraordinary operating and business risks, interest rate and leverage risk, macroeconomic and public market risks, and dilution risk.

1. Liquidity Risk: Private equity investments have long investment periods of up to 10 years with limited sale opportunities compared to public markets, leading to liquidity risk. The bid-offer spread on secondaries offered for sale or purchase by general partners and other investors lacks the transparency of exchange-traded instruments and may widen significantly under adverse public market conditions.
2. Valuation Risk: Private market valuations for partnerships and co-investments are influenced by the chosen methodology, inputs, and judgement of a general partner rather than an independent third party or as observed in public market prices. Private valuations often use income-based discounted cash flow (DCF) analysis based on risk-free rates, public credit spreads, public market multiples, and recent public transactions. Valuation risk arises not only due to this potential bias but also the delayed timing of private market valuations received by investors.
3. Agency Risk: Asymmetric information between a general partner and limited partners can lead to a potential misalignment of interests. Performance and other incentive-based fee structures for GPs and share-based compensation for private company managers are potential mitigants to this risk. However, private firms lack the corporate transparency of publicly traded firms, and investors are often unable to exercise voting rights similar to public company investments.
4. Extraordinary Operating and Business Risks: The investment focus of venture capital, growth equity, and buyout situations may involve exceptional operating and business risks, which may result in a substantial loss of capital. Unrealized assumptions in the ex-ante financial analysis may have large impacts on realized returns.
5. Interest Rate and Leverage Risk: In the case of buyout equity where significant leverage is used, rising interest rates and credit spreads increase the cost of debt and potentially impair the ability to realize financing on attractive terms.
6. Macroeconomic and Public Market Risks: Private equity investments face unique risks related to the entry and exit value of equity. For example, in a strong market environment, competition for undervalued assets may be high and drive up the cost of investments, while in an adverse market scenario, depressed market multiples may reduce the potential return on investment for a planned exit.
7. Dilution Risk: The potential for dilution is also a consideration for investors, whether that includes later-stage series financing for early-stage companies or the dilution arising from share-based compensation to company managers in the case of buyout equity.

Private equity investments are associated with higher costs and fees compared to public markets. These include higher management fees and performance-based compensation, transaction fees, fund setup costs, and administrative costs. Investors manage private equity risks through thorough due diligence of fund managers for co-investment and limited partnership investments as well as diversification by geography, industry, vintage year, and investment strategy.

Practice Questions

Question 1: Private equity is a distinct asset class that offers investors the chance to achieve high risk-adjusted returns and diversification benefits compared to public equity holdings. This is due to the specific investment focus of venture capital, growth equity, and buyout equity strategies. Investors often seek diversification within private equity strategies by allocating investments across different vintage years and various investment managers. Which of the following statements is most accurate?

1. Private equity returns are always higher than public equity returns.
2. Private equity returns can diverge from public markets under normal market conditions, particularly if the entry involves a take-private transaction and they exit an initial public offering (IPO).
3. Private equity investments do not provide exposure to specialized areas of the economy.

Answer: Choice B is correct.

Private equity returns can indeed diverge from public markets under normal market conditions, particularly if the entry involves a take-private transaction and they exit an initial public offering (IPO). This is because private equity investments are often made in companies that are not publicly traded, and the returns on these investments can be influenced by a variety of factors that are not directly tied to the performance of the broader public equity markets. For example, the success of a take-private transaction can depend on the ability of the private equity firm to improve the operational efficiency of the company, which may not be directly related to the overall performance of the public equity markets. Similarly, the success of an IPO exit strategy can depend on the timing of the IPO and the market conditions at the time of the IPO, which can also diverge from the overall performance of the public equity markets.

Choice A is incorrect. It is not accurate to say that private equity returns are always higher than public equity returns. While private equity has the potential to generate higher returns than public equity, this is not always the case. The performance of private equity investments can vary widely, and there are many instances where private equity investments have underperformed relative to public equity investments.

Choice C is incorrect. Private equity investments can indeed provide exposure to specialized areas of the economy. In fact, one of the key advantages of private equity is that it allows investors to gain exposure to sectors and companies that are not typically accessible through public equity markets. This can include sectors such as technology, healthcare, and consumer goods, among others.

Question 2: Private equity investments, including venture capital, growth, and buyout equity, are known for their high expected returns. However, they also come with a variety of risks. One such risk is the liquidity risk. Which of the following best describes the liquidity risk?

1. The risk that the bid-offer spread on secondaries may widen significantly under adverse public market conditions.
2. The risk that the chosen methodology, inputs, and judgement of a general partner may influence private market valuations.
3. The risk that asymmetric information between a general partner and limited partners can lead to a potential misalignment of interests.

Answer: Choice A is correct.

Liquidity risk in the context of private equity investments is best described as the risk that the bid-offer spread on secondaries may widen significantly under adverse public market conditions. Private equity investments are typically illiquid, meaning they cannot be easily sold or exchanged for cash without a substantial loss in value. This is due to the long investment periods and limited sale opportunities compared to public markets. In times of market stress or adverse conditions, the bid-offer spread on secondaries (i.e., the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept) can widen significantly. This can make it even more difficult for investors to exit their positions, thereby increasing the liquidity risk. This risk is a key consideration for investors in private equity, as it can impact their ability to realize returns and manage their investment portfolios effectively.

Choice B is incorrect. The risk that the chosen methodology, inputs, and judgement of a general partner may influence private market valuations is more related to valuation risk than liquidity risk. While this risk can impact the perceived value of a private equity investment, it does not directly relate to the ability to sell the investment or convert it to cash.

Choice C is incorrect. The risk that asymmetric information between a general partner and limited partners can lead to a potential misalignment of interests is more related to agency risk or information risk. While this risk can impact the performance of a private equity investment, it does not directly relate to the ability to sell the investment or convert it to cash.

Glossary

• Private Equity: A type of investment that involves buying shares in private companies or buying out public companies to make them private.
• Venture Capital: A type of private equity investment that is made in startups or small companies that have the potential to become large.
• Growth Equity: A type of private equity investment in companies that are looking to expand or restructure operations, enter new markets, or finance a significant acquisition without a change of control of the business.
• Buyout Equity: A type of private equity investment where a company is bought out by a private equity firm and made private.
• Liquidity Risk: The risk that an investor will not be able to sell their investment when they want to or will have to sell it at a loss.
• Valuation Risk: The risk that an investment’s value will be inaccurately estimated.
• Agency Risk: The risk that the interests of investors and managers will not align.
• Interest Rate Risk: The risk that an investment’s value will change due to a change in the absolute level of interest rates, the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship.
• Leverage Risk: The risk associated with the use of debt to finance an investment, which can magnify both gains and losses.
• Macroeconomic Risk: The risk that economic developments, such as inflation or recession, will affect an investment.
• Public Market Risk: The risk that the value of an investment will decrease due to moves in the market.
• Dilution Risk: The risk that the value of an investment will decrease due to the increase in the number of shares.

Private Markets Pathway Volume 1: Learning Module 3: Private Equity; LOS 3(e): Discuss the risk and return among private equity investments as well as versus other investments as part of a strategic asset allocation