As the US economy has grown, public markets have become increasingly concentrated in fewer, larger companies. In 1996, roughly 8,000 firms were listed in the US stock market. Since then, the national economy has grown by nearly $20 trillion and yet, today, the number of American public companies stands at fewer than 4,000.1
This shift presents challenges for thoughtful investors:
- Fewer hands now direct the path of broad indices;
- The stock market is less reflective of the wider economy; and
- More capital is crowding into fewer positions, dampening volatility in tranquil markets and amplifying it in turbulent ones.
Institutions have long valued PE for its alpha potential. They are increasing allocations now to counteract public market concentration, recognizing that PE diversifies factor exposure and provides stability in volatile markets. Moreover, certain innovations are making PE more accessible for individual investors.
What is private equity?
Private equity entails investing in privately held companies that span from start-ups to mature enterprises, across a range of investment strategies and risk-return profiles (Figure 1). These are the most common:
- Venture capital (VC) offers investors the opportunity to acquire stakes in early-stage companies. VC has the highest potential returns, but the greatest challenges to accessing those returns, and the longest duration.
- The largest and most common strategy, leveraged buyouts (LBOs) apply debt or “leverage” to purchase mature enterprises with the goal of making them more efficient and profitable. LBOs have an attractive return profile, and shorter duration than VC or growth equity.
- Often regarded as a hybrid of VC and buyouts, growth equity refers to investing in high-growth companies that are at the inflection of profitability. Often, these businesses were “bootstrapped” by founders and are just now experiencing institutional ownership.
PE managers (aka general partners or GPs) are critical to monitoring and advising their portfolio companies. They seek to create value by directly influencing a company’s strategy and performance, as well when to exit the investment—whether through a sale to another GP, a corporate or an IPO. Manager selection is one of the most important and difficult aspects of investing in private equity.
Why invest in private equity?
Outperformance
PE has consistently delivered strong returns, surpassing those achieved in public markets over moderate time horizons. PE has outperformed public markets by an average of 514 basis points over the past four decades (Figure 2). Unlike public markets, where investments are passive and more subject to market volatility, private equity allows investors to implement strategic improvements, drive operational efficiencies and leverage long-term growth potential.
Diversification
LBOs have lower correlation with a traditional 60/40 portfolio than the S&P 500 (Figure 3). Although buyouts tend to move in the same direction as public markets, their returns are not fully driven by public market dynamics. This partial independence allows PE to add stability to a portfolio and may reduce the impact of market downturns.
Capital preservation
Additionally, private equity has demonstrated resilience during economic downturns, preserving capital more effectively than public markets. Over the last four crises, PE valuations on average have fallen by roughly half as much as public equity markets (Figure 4).
Investment structures
Primary funds (aka commingled or closed-ended funds) are blind pools of capital whereby an investor (aka a limited partner or LP) commits capital upfront, before the fund manager has identified any assets to invest in. Once the GP finds an asset to invest in, the LPs contribute a portion of their committed capital. The invested capital is typically held for around five years—a bit less for LBOs, a bit more for VC. This uncertainty around the timing of when capital is contributed and returned makes liquidity management a challenge for investors. However, by committing to many funds every year, investors can have relatively predictable cash flows from their PE portfolio. Owing to high commitment floors, investing in primaries is typically only available to institutions and high-net-worth investors.
Co-investments allow investors to invest alongside a GP—often on a “no fee, no carry basis.” This allows them to gain critical insights into the strength of the asset and the GP’s investment team. Co-investors must move quickly, and often deploy specialized teams to execute deals. Co-investment without a primary fund portfolio is very difficult, as it significantly reduces deal flow.
Secondaries refer to purchasing stakes in an individual company or a primary fund, often at a discount. The sales process can be GP- or LP-led. Because the manager has already put capital to work improving the asset(s), the buyer may be purchasing the asset(s) when cashflows are trending upward.2 In addition, these transactions usually take place after the investment period, when fees are trending lower. Like co-investments, investing in secondaries requires teams with advanced financial skills and access to proprietary data.
Evergreen funds have emerged as a convenient and efficient way for individuals to access PE. Because these structures draw and deploy investors’ capital continually, they can effectively compound that capital and resolve some of the liquidity challenges that other structures can present. Though initially conceived with the individual in mind, institutions are increasingly using evergreens in their PE portfolios.
Evergreens have many advantages including lower minimum investments, higher liquidity, and simpler taxes. However, their fees are higher than other retail products, including mutual funds.
Conclusion
As investors navigate a shrinking and increasingly concentrated stock market, private equity stands out as means for investors to potentially generate high returns, diversify their portfolios and preserve capital during economic downturns.
Each PE strategy offers benefits and considerations, from potential high returns and enhanced diversification to varying levels of liquidity and fee structures. For newer investors, partnering with an experienced private equity manager is essential to understanding this rich and varied asset class.
1 Nicole Goodkind, “America has lost half its public companies since the 1990s. Here’s why.” CNN, June 9, 2023.
2 In industry parlance, we say on the upswing of the “J curve.”
