Hidden in Plain Sight: Private Equity, Part 2
June 30, 2022 - Private equity investing differs from public equity investing in significant ways. Having defined private equity (PE) in Part 1, we now consider private equity's key characteristics.
A private equity investment may take several years to realize a return. Because of this long-term investment horizon, private equity funds are often illiquid and limit an investors’ ability to withdraw their investment. The fund vehicles through which GPs make investments typically have ten-year lives with no redemption provisions. The holding period of a fund’s underlying private companies before the GP can sell them can range from 2 to 10 years. Additionally, unlike traditional stocks and bonds, there is not a readily available public exchange that facilitates the buying and selling of private equity investments. Investors assume then that PE is a long- term asset class and expect that the returns will be commensurate with the uncertainty and risk of time and liquidity.
Unlike stocks, which can be immediately sold for their most recent carrying value, there is no contemporaneous pricing mechanism for PE. Private equity investments are valued quarterly using standardized inputs and assumptions. Values are reported months in arrears and returns are evaluated on an annual basis. This means private companies aren’t priced as efficiently as public companies. PE firms can take advantage of this mispricing and potentially earn higher returns. Importantly, because the prices of private equities and public equities are not always correlated, adding private equity to a muti-asset class portfolio (such as HighGround's) provides the benefit of diversification in the timing and magnitude of equity returns.
This is probably one of the most important differences between PE and public company ownership. Public company management are beholden to numerous minority stakeholders (individual shareholders, Wall Street analysts and media, institutional investors, etc.), all of whom can have an impact on a company’s current valuation. In the private markets, the GP owning a significant portion of the equity has a higher degree of control over a company’s fortunes and is the primary determinant of important corporate decisions, while being outside the lens of public scrutiny and generally not subject to immediate market expectations.
Another significant difference is the ability for the GP to add value to an investment by making strategic and financial decisions that impact the growth and profitability of the company. This includes making acquisitions, improving operations, refining the capital structure, making leadership changes, adding resources and, importantly, determining when to sell an investment. The goal is that the execution of their value creation strategy will be reflected in a higher value for the company, perhaps at a significant multiple over their price at acquisition.
ALIGNMENT OF INTERESTS
Private equity investors have a greater level of alignment with private fund managers, primarily due to the significant amounts of capital being committed by both parties to the same investments. By rule, the fund manager will make a meaningful cash commitment to each fund they manage (known as the “GP commit”) and in addition to their participation in the profits of the fund over time, these are powerful incentives to perform well. There is no such alignment in public equity fund management.
While there are approximately 6,000 companies publicly listed on the NYSE and NASDAQ exchanges, it is estimated that there are at least 100x that amount of privately owned companies in the U.S. today. With only 3% of these companies owned by private equity firms, there remains a broad and widely fragmented opportunity set of companies to invest in. Many of these companies are family or founder owned, may be looking to sell (succession, retirement, etc.), or might want to continue their growth and require capital and management expertise to do so. There are a multitude of investment opportunities in the private market, depending on the economy and specific company/sector dynamics. Private equity funds proactively target these opportunities and seek to provide a ready source of investment capital to the private market through all market environments.
PRIVATE EQUITY IN THE WILD: As Limited Partner, HighGround has a direct link to a variety of private equity-backed businesses that make our daily routines more convenient, efficient and secure. HighGround’s compliance and training platform runs on software created by KnowBe4, a developer of security awareness and training solutions. The company is backed by GP’s Ten Eleven Ventures and Vista Equity Partners. HighGround is an LP with both private equity firms.