Moxie FuturePrivate equity (‘PE’) refers to investment in private companies that have not “gone public” (i.e. companies that have not listed on a public stock exchange). In their simplest form, private equity firms comprise investors who want to invest directly in companies, rather than buying company stock – pooling money into private equity ‘funds’.
Private equity firms raise capital from different sources, such as pension funds, insurance companies, endowments and high net worth individuals. These investors band together as Limited Partners (LPs) with a fund manager – known as the General Partner (GP) – who is responsible for leading and managing the fund. Often taking a majority stake in investee companies, the PE firm aims to improve the operational performance of the companies it invests in, by increasing growth and / or cutting costs, with the objective of selling the investee company for a profit at a later date.
Unlike other asset classes where money is drawn down all at once, private equity commitments are drawn down as investments into the underlying companies are made. Because these funds are structured as long-term investment vehicles, LPs are often required to commit their capital for the fund’s total life – typically 10 years. A fund’s life cycle is usually broken down into an initial five-year investment period followed by a five-year divestment period.
Private equity and venture capital funds generate returns by selling their stake in a business for a higher price than initially acquired for, thereby creating a capital gain. This process is called an ‘exit’ and is achieved through selling the stake in the company, possibly through:
Generally, the exit takes place somewhere between three and seven years after the original investment, representing long-term ownership during which significant operational and other changes can be made.
Private equity investors are usually looking to improve the risk and reward characteristics of an investment portfolio. Investing in private equity can offer the opportunity to generate higher absolute returns whilst improving portfolio diversification. Investors like private equity for different reasons including:
Private Equity: Private equity investors are all about improving a current business in order to make the company (more) profitable. They typically buy out the business in its entirety, in order to have the freedom to restructure it. Private equity firms will then do everything in their power to turn the business around, often bringing in new management and changing methods to become more profitable.
Venture Capital: Venture capital investors are about finding good deals in young businesses and new companies. Venture capitalists may own a portion of a business but, in contrast to private equity firms they rarely buy a company outright. They offer to invest a set amount of money for a stake in the company. Venture capitalists may want a say in how the company is run or alternatively be very hands-off.
Investing in private equity is very different from investing in the public markets. And it’s a risky business because, if the investee company stumbles, the private equity fund and its investors will lose money. As with all investments, it is very important to know where the potential risks lie – here are just a few to consider:
As an individual investor it is not an easy asset class to get in to – historically reserved for large pension funds and university endowments. Typically only the wealthiest can afford the large sums demanded for direct access to private equity funds run by famous names such as Blackstone, Apollo and Carlyle. Many funds may require a minimum investment of US $1m, $5m or more. This is compounded by high fees.
But equity crowdfunding is changing this, allowing anyone to invest in non-public companies. Equity crowdfunding enables broad groups of investors to come together via an online platform to fund startup companies and small businesses in return for equity. Investors invest their money in a business and receive ownership of a small piece of that business. If the business succeeds, then its value goes up, as well as the value of a share in that business – but of course, the converse is also true.
The good news is that, over the last couple of years, some of the biggest and best-known private equity firms have begun to get more serious about responsible investment and ESG (environmental, social and governance) practices. Why? Because smart managers are seeing the value that managing ESG risks can bring, particularly on exit. It has also been driven by strong client demand, investors that recognize it is not necessary to trade off financial return for positive societal and environmental impact.
Interestingly, some PE firms have also begun to design ‘impact strategies’ and launched funds on the back of these – such as TPG’s Rise Fund, BainCapital’s Double Impact and KKR’s Global Impact. These types of funds have a well-established process, tending to define ‘impact or community investing’ in line with the definition offered by the GSI Alliance.
Undeniably, responsible investment is an important opportunity for the private equity industry. Given typical investment timelines, private equity firms are well-positioned to hold long-term perspectives and care about long-term outcomes. In addition, PE firms often buy controlling stakes in companies, with a board seat included, and so can exert influence to make the kind of changes needed for long-term sustainability strategies and projects.
Private equity is a critical part of mobilizing the global capital needed to achieve the 2030 Sustainable Development Goals. However, for individual investors, it can be difficult to get exposure to this asset class as the required minimum investments tend to be very high (> US$1m, $5m or more).
That said, many individuals will have exposure through their pension funds as today many include private equity in their portfolios. In some markets, pension funds have become strong advocates for responsible and sustainable investment practices. For example Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, announced in July 2017 that it would increase its ESG asset allocation from 3 to 10 per cent. In 2018, New York City announced that its public pension funds would be divesting US $5 billion from fossil fuel companies within five years. Take a look at how is your pension fund invested … does it live up to your expectations on sustainability issues? If not, can you contact them to push for progress?
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