iCapital serves some of the largest and most respected private equity firms in the world as a technology-enabled alternative investment platform. Our firm also manages proprietary private equity funds as an alternative asset manager. In this private equity primer, we provide a comprehensive overview of private equity investing, which continues its ascent to the top of the alternative investment industry. This whitepaper is provided in Q&A format and raises questions that a fiduciary or trustee might typically ask when considering an investment allocation to this asset class.
Q: WHAT IS PRIVATE EQUITY?
A: Despite its aura of complexity and sophistication, few investment terms are as clear as private equity (PE). Private equity is simply a private ownership interest in a private asset, most often a company. The overarching mission of private-equity investing, like its name, is also straightforward: bring about positive change in a company that increases its value. In other words: buy, change, and sell. Value-creation activities in PE investments, called “portfolio companies,” can include: financing an acquisition, taking a public company private to implement a long-term strategy, or restructuring a company’s balance sheet.
Q: IS PRIVATE EQUITY A NEW INVESTMENT STRATEGY?
A: Although the private equity industry has expanded greatly over the last two decades, it is not a new endeavor. Affluent individuals and institutions have invested in private assets and entities since the industrial revolution.
In 1852, Brothers Emile and Isaac Péreire established a Paris-based private merchant bank, Crédit Mobilier, widely considered one of the world’s first private equity operators. A major source of funding for Europe’s economy in the mid-19th century, Crédit Mobilier provided capital to companies and major infrastructure projects.
Due to restrictions imposed under the Glass-Steagall Act in 1933, private merchant banks were unable to operate in America.1 Wealthy families, such as the Rockefellers, Vanderbilts, and Warburgs, filled the void, making private equity their province in the early-to-mid 20th century. Laurence Rockefeller, for example, funded the creation of Eastern Air Lines and Douglas Aircraft.
The modern PE industry was largely conceived by a handful of American corporate financiers, most notably Jerome Kohlberg, Henry Kravis, and George Roberts (now known as KKR). The trio began making a series of “bootstrap” investments in family-run businesses, which faced financial and succession issues in the 1960s. KKR’s acquisition of Orkin Exterminating Company in 1964 is considered the first leveraged buyout (LBO) transaction in U.S. history.2
In 1980, just 24 private equity firms were operating across the globe. Despite the small number of active firms, a handful of large endowments and foundations began allocating a small percentage of their portfolios to private equity in the 1980s. By 2015, just 35 years later, more than 6,600 new private equity firms had entered the private equity arena, a 109,600% increase in operators.3 Private equity assets under management (AUM) have followed suit. As of calendar 2017, total private equity AUM stands at more than $5.2 trillion, up from $4.7 trillion in 2016.4 Yale University, one of the earliest PE adopters, has continued its strong support of the asset class. As of June 30, 2018, Yale, which has a ~$30 billion endowment, has allocated more than 30% of its portfolio or ~$9 billion to private equity strategies.5
In calendar 2018, leading PE firms continue their search for new sources of capital—and have set their sights on the wealth management industry and individual investors. In April 2018, Blackstone, one of the industry’s four largest PE firms, announced an expansion of its private wealth unit. A Blackstone spokesperson stated that half of the firm’s assets may come from individual investors in the next ten years.6
Today, it’s critical that individual investors, and their advisors, understand what private equity is and does—and what benefits it can provide to investment portfolios.
“In 1980, just 24 private equity firms were operating. By 2015, more than 6,600 new firms had entered the private equity arena.”
Q: HOW DO INVESTORS ACCESS PRIVATE EQUITY?
A: Seven primary vehicles exist to invest in private equity, as outlined below.
1. Private Equity Funds: By far the most popular PE vehicle, private equity funds—also known as “primary funds” or “primaries” are pooled investment vehicles structured as limited partnerships. In early 2018, a record 2,296 private equity funds were active in the market, seeking to raise more than $740 billion, a 25% increase over 2017.7 Private equity funds continue to dominate the marketplace as the vehicle of choice for institutional and high-net-worth individual investors.
2. Secondaries: The secondary market is focused on the buying and selling of investors’ interests in primary fund investments, hence its name. With primary funds being illiquid and having a capital lock-up of ten years, the transfer of a limited partner’s interest can be complex and take months to complete. For calendar 2017, transaction volume in the PE secondary market surged to $54 billion, surpassing the $47 billion record in 2014.8
3. Fund of Funds (FOFs): These vehicles pool capital to invest in a portfolio of five or more private equity funds. FOFs were created for capital-constrained investors, such as high-net-worth families and smaller institutions, who lack the capital to build an entire PE investment program. The FOF format provides diversification and economies of scale, but an added layer of fees. FOFs typically charge annual management fees of 1.0% and a 5.0% performance fee on gains, on top of the fees charged by private equity funds.9 The private equity FOF industry stood at a significant $381 billion in AUM for calendar 2016.10
4. Interval Funds: Originally created in 1990, interval funds, like private equity, are not a new development.11 An interval fund is a continuously offered closed-end fund that periodically offers liquidity or redemptions, like many hedge funds. Currently, there are 43 interval funds in existence, with PE-focused interval funds coming in at ~20% of the total.12 Industry insiders have recently remarked that the rebirth of interval funds is creating a favorable new liquidity structure for investors and alternative asset managers.13 Over the past year, these funds have increased their assets by more than 50% to $25 billion in assets under management, according to Interval Fund Tracker.
5. Publicly-Traded Private Equity Funds: Exchange traded funds (ETFs) and open-end mutual funds categorized as “private equity,” can, in reality, only mimic the asset class. These vehicles typically hold three types of public securities to simulate the performance of PE funds: 1) Stocks of publicly-traded private equity firms, such as KKR (NYSE: KKR); 2) Stocks of public companies that may compare to private PE portfolio companies; and 3) Stocks of business development companies (BDCs), which also provide capital to private companies like PE firms. The knock on these publicly-traded PE vehicles is two-fold: sky-high expense ratios and a high correlation to small-cap value funds, rather than PE funds.14
6. Co-Investment: Considered the most complicated of the four vehicles, equity co-investments enable qualified investors to invest alongside a private equity firm without paying the usual fees charged by a fund manager. Co-investment opportunities are typically restricted to large institutional investors who already have an existing relationship with a private equity firm. According to a recent ValueWalk study, more than 80% of LPs reported better performance from co-investments as compared to traditional commingled fund structures.15
7. Direct Investments: The overwhelming majority of PE investors don’t possess the advanced capabilities and resources required to invest directly in portfolio companies. Direct investing, like co-investment, is reserved for institutions looking to secure a larger share of PE profits by managing their own in-house private equity investment team. Although many institutions have intentions of building their own direct PE programs, few have done deals on their own. Of the 308 direct deals completed by limited partnerships in 2017, only 62 or 20% were solo deals, where the LP invested alone, without a co-investor.16
RISKS AND OTHER IMPORTANT CONSIDERATIONS
Certain statements are based on the subjective views, beliefs and opinions of iCapital and its personnel. Such statements are subject to change and cannot be independently verified. It is important to note that all investments are subject to risks that affect their performance in different market cycles. There are significant differences between public and private equities, which include but are not limited to, the fact that public equities have a lower barrier to entry than private equities. There is also greater access to information about public companies. Private equities typically have a longer time horizon than public equities before profits, if any, are realized. Public equities provide greater liquidity, whereas private equities are considered highly illiquid. There can be no assurance any such trends or correlations would persist in the future.
All performance, assets under management, number of employees/investment professionals, of ces, and active investments are as of December 31, 2020, unless otherwise stated.
1. The Glass-Steagall Act was passed by the U.S. Congress in 1933, prohibiting commercial banks from participating in the investment banking business.
2. A leveraged buyout (LBO) is a nancial transaction in which a company is purchased with a combination of equity and debt. The use of debt, which has a lower cost of capital than equity, serves
to reduce the overall cost of nancing the acquisition. The cost of debt is lower because interest payments reduce corporate income tax liability, whereas dividend payments do not.
3. Source: David Parkins, “Private Equity: The Barbarian Establishment” (The Economist, October 22, 2016).
4. Source: Fredrik Dahlqvist, Aly Jeddy, Bryce Klempner, Alex Panas, Vikek Pandit, and Matt Portner, “The Rise and Rise of Private Markets: McKinsey Global Private Markets Review”
(McKinsey & Company, February 2018).
5. Source: “Yale University Endowment Update 2017” (Yale Investments Of ce, 2018).
6. Source: Heather Perlberg, “Blackstone Lures Investment Clients with Help of Adviser School” (Bloomberg.com, April 24, 2018).
7. Source: Jasper Espinoza, “Private Equity Funds Active in Market Reach All-Time High” (The Financial Times, April 24, 2018).
8. Source: Rod James, “Secondaries Deal Volume Smashes Previous Record” (SecondariesInvestor.com, January 22, 2018).
9. Source: Carla Fried, “Only One Type of Private-Equity Fund of Funds Earns Its Fees” (Chicago Booth Review, June 19, 2017).
10. Source: “Private Equity Special Report: Private Equity Fund of Funds,” (Preqin.com, November 2017).
11. Source: Mary Childs, “A Safer Way to Invest in Private Debt” (Barron’s, September 21, 2018).
12. Source: Bill Hortz, “Interval Funds—A Fund Structure Who’s Time Has Come?” (Financial Advisor Magazine, January 23, 2018).
13. Source: Kristen Haunss and Yun Li, “New Interval Funds Offer Alternative Investments to Retail Investors” (U.S. News & World Report, May 11, 2018).
14. Source: John Waggoner, “Listed Funds Offer Access to Private Equity with Liquidity” (InvestmentNews, April 10, 2017).
15. Source: Sheeraz Raza, “Investors See Their Co-Investments Outperform Commingled Funds” (ValueWalk, November 12, 2015).
16. Source: Markus Massi, Vinay Shandal, Mark Harris, and Kathleen Bellehumeur, “A Hands-On Role for Institutional Investors in Private Equity” (The Boston Consulting Group, February 2018).
IMPORTANT INFORMATION / DISCLAIMER
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security offered by Institutional Capital Network, Inc. or its affiliates (together “iCapital Network”). Past performance is not indicative of future results. Alternative investments are complex, speculative investment vehicles and are not suitable for all investors. An investment in an alternative investment entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital Network assumes no liability for the information provided.
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