Why there’s a place for private equity in your portfolio

That it’s become mainstream for large investors seeking attractive risk/return trade offs beyond traditional markets should not be lost on retail investors.

A decade ago private equity was considered to be a fringe asset class but today it is generally accepted by most largely global sophisticated institutional investors (such as sovereign wealth funds) as a distinct and very material part of their portfolios.

Private equity is an equity investment into private (unlisted) companies through a private equity fund. These funds are managed by private equity managers who are different from fund managers – the latter generally invest in listed companies while the former tend to get integrally involved in the companies they invest with.

The different forms of private equity include:

• Buyouts, which are investments into established companies that generate strong cashflow profits;
• Venture capital, investments into newly established (and very often technology based) businesses; and
• Growth capital, investments in high-growth companies that usually are not yet profitable.

On the risk/return spectrum, in general buyouts are the least risky, followed by growth capital and then venture capital.

The Future Fund, Australia’s sovereign wealth fund, had 16 per cent of its portfolio allocated to private equity according to its 2018-19 annual report. By comparison, the Future Fund had only 7 per cent allocated to Australian equities.

“Most Australian retail investors are heavily invested into Australian and global equities with very little (if any) exposure to private equity,” says Russel Pillemer, CEO of Pengana Capital. “However global private equity has been a superior asset class over the last couple of decades, generating materially higher returns than global listed equities and also with a low correlation to listed equities.”

Wendy Norris, deputy CIO of the Future Fund, said last year at a presentation to the Australian Investment Council that the large buyout space can provide options “to invest in high ‘alpha’ (returns above market) opportunities, where we believe we can earn a significant premium over similar – but more liquid – public market equity investments”.

Norris also highlighted the “emphasis Future Fund has placed on private markets investments reflects a powerful trend in global investment flows”. “Over the past 20 years we have witnessed a strong and sustained shift in the market landscape, with growing private markets on one hand and shrinking public markets on the other.”

Pillemer adds: “Most Australian investors are unaware that global listed equity markets are shrinking at a rapid rate – especially in the US where the number of listed companies has fallen over the last two decades from 9000 to less than 4000. The reason for this fall is that there are many impediments to small- to medium-sized companies being listed.”

Liquidity is one of the challenges retail investors face with private equity as the asset class by definition is relatively illiquid. Private equity fund offerings in Australia have historically largely been closed-ended funds offering investors little in the way of liquidity.

It is challenging for retail investors generally to access top tier global private equity managers as the minimum investment levels are normally $10 million. Leading managers are almost always oversubscribed so they tend not to accept new investors.

More recently some investment groups such as Pengana and Evans Dixon have provided investors with the opportunity to invest in private equity through a listed vehicle. Investing through a listed vehicle goes some way to addressing the liquidity issue, but investors need to be aware that the price can trade at a discount to asset backing, which is the case with the Evans Dixon funds.

The Pengana vehicle partners with US heavyweight Grosvenor Capital Management, which then invests across a number of top tier private equity funds with a good track record and targets an income rate of 4 per cent a year. This would help explain why the Pengana fund trades at a premium to asset backing.

Private equity markets have graduated to the mainstream of portfolio construction for large investors seeking attractive risk/return trade offs beyond the traditional markets. This trend should not be lost on retail investors.

Source: Financial Review

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