Private Equity Investing
Large transactions over the past two years have drawn a significant amount of attention to the private equity asset class. Bain Capital, KKR and Merrill Lynch, for example, teamed up to pay $21 billion to acquire hospital operator HCA, Inc. The Blackstone Group, another large private equity manager, recently announced it was filing documents for an initial public offering, and that it would pay $23 billion to acquire Equity Office Properties. Institutional portfolio managers have attempted to capitalize on this trend by allocating as much as 10% – 20% of their portfolios to private equity.
Private equity represents an ownership position in a company that is not publicly traded and offers the potential for investment returns which exceed that of the public equity markets. In fact, data from Venture Economics indicate that private equity has delivered more than a 16% annualized return from 1996-2005, outperforming public markets by more than 6% per year. Another major advantage of investing in private equity is that its returns are not highly correlated to public equities, which provides additional diversification to a traditional portfolio of stocks and bonds. Adding private equity to a diversified portfolio can potentially increase its expected return and reduce risk.
A word of caution: private equity is not suitable for all investors. The investment is very illiquid—private equity funds often have terms that tie up capital for as long as twelve years. In addition, minimum investment thresholds are often very high. Consequently, private equity investors must have a long-term investment horizon and meet the “accredited investor” standard, which currently requires a net worth of at least $1 million (though this may be increasing).
Allocating to the private equity asset class is only part of the initial decision making process. There are other factors that must be considered when constructing a portfolio that contains private equity. For qualified investor portfolios, Truepoint attempts to diversify private equity investments across several different managers, styles, sectors, investment stages and geography to take full advantage of the asset class, while reducing the risk associated with these factors. In portfolios that Truepoint constructs, we may allocate between 5% and 15% of the portfolio to private equity depending on the extent of other alternative investments.
More so than in public equities, private equity manager selection is vitally important. In fact, the performance differential between the median performing private equity manager and the top quartile performing private equity manager is quite significant. The primary driver behind the performance differential is that investing in private companies requires a specialized set of skills. Therefore, gaining access to these top managers is often critical to success in private equity investing.
Private equity is a compelling opportunity that, where appropriate, investors should consider given its potential to deliver both enhanced returns and additional portfolio diversification.