Private Equity (“PE”) has established itself as an asset class and has become an increasingly central part of the asset allocation of both institutional and private investors. The system has many advantages. In this post, we intend to address the key drivers of better private equity performance, provide an overview of the returns that can be expected from a diversified private equity portfolio, and propose a framework for building a portfolio in light of planetary boundaries.
Investing in private equity is like investing in the real economy as it directs capital to companies and their founders. The core of the private equity investment model is the relationship between the fund manager as the “principal” and the corporate manager as the “agent”. We believe that private equity is characterized by a better alignment of interests of particular groups of stakeholders for various reasons. As majority or significant minority owners of companies, private equity investors are usually directly involved in shaping the companies and their management teams and support their operations with additional strategic and operational advice. This is only possible with full control or significant influence over the company’s management. Examples include the ability to quickly replace or augment weaker leadership teams, the ability to appoint directors who typically have the appropriate industry experience and network to add value, and the freedom not to deal with minority shareholder distortions or the need to deal with pressure from minority shareholders. activists investors. Private companies owned by professional private investors are also immune to overly stringent regulatory requirements in public markets, the main purpose of which is to protect retail investors.
Private equity fund managers are also able to achieve significant synergies within their portfolios, with an increasing number of fund managers specializing in the specific sectors in which they have accumulated the most experience.
Another driver for better convergence of interests is the longer investment horizons of private equity investors. Private investors, in particular venture capital fund managers, can support loss-making companies for many years, allowing them to focus on product and service development, leading to a higher level of innovation. Private equity firms may take longer to implement their strategic moves as they do not face the same pressure from stakeholders to meet and exceed quarterly earnings forecasts.
In addition, specific private equity incentives are also an additional factor in providing a better performance compared to listed shares. Fund managers and management teams of their portfolio companies are primarily remunerated in the event of a successful liquidity event, i.e. when the portfolio company is sold or goes public. A liquidity event is usually preceded by extensive due diligence by the buyer and a competitive auction process providing some certainty about the fundamental value of the transferred business. This type of performance fee (or “insured interest rate”) rewards long-term fundamental value creation. It can also be assumed that private equity incentive mechanisms attract more talented management teams. Private equity company managers and founders typically receive some of the proceeds from a successful sale, often in the form of large stakes.
Do private equity firms outperform comparable publicly traded firms?
Most Alternate Asset Classes require special performance measurement tools. Private equity is no exception; the three performance indicators listed below are the most commonly used. Total value to be paid (TVPI) is the sum of the payments received and the residual value of the investment divided by the capital invested. The split into paid (DPI) ratio measures the “level of execution” of an investment by comparing payouts to capital invested. The DPI indicator shows how far below or above the return (DPI = 1.0x) a given private equity investment is currently positioned. Finally, as a money-weighted performance measure, internal rate of return (IRR) is best suited for private equity investments as the timing and volume of cash flows must be considered when assessing a fund manager’s performance.