For decades, institutional investors have been investing in private equity because of its double-digit returns, low correlation with quoted markets and resilience.
Private equity has delivered average returns of 14.9 per cent over the past 10 years, with the small buyout sector being the best performer of the market.
Private equity should not be confused with investments made by venture capital investors. While both investment types are made into private companies, venture capital investments are made into early-stage, normally pre-profit and often pre-revenue businesses.
While these businesses have the potential for generating high returns, they also carry a commensurately high risk. Instead, private equity investments are made into pre-existing, often long-established companies, usually involving the buyout of one or more shareholders.
While institutional investors have been allocating 5 per cent or more of their assets to private equity for many years, it is only relatively recently that high-net-worth and sophisticated private investors have been attracted to the asset class.
Just like the institutions, they have been drawn to private equity as a way of diversifying portfolios and accessing the potential for strong returns – something particularly relevant in an era of very low interest rates.
Among the high-net-worth market, entrepreneurs have embraced private equity the most. Successful entrepreneurs are typically business savvy and highly driven individuals, with a clear vision of what they want to achieve.
But for most, there always comes a time to sell their company, whether it be when all their goals are achieved, they want to retire, or someone offers a price that’s too good to refuse.
So what happens next? Taking a long holiday might come first, but that’s the easy bit. When the suntan has faded there is a real job to be done: how to invest the £50m, £100m or more they have realised, which is no small task – albeit there are plenty of advisers on hand to help.
Investment in property and a portfolio of stocks and bonds will no doubt form part of the solution, but entrepreneurs, who may already have personal experience of the power of private equity to fuel growth, will often set aside a ‘play pot’ for investing in small businesses, often taking 100 per cent ownership and becoming actively involved.
The problem with this ‘direct’ private equity approach is that once you have invested in a few businesses you can soon run out of bandwidth to manage these investments, and you end up with a relatively high concentration of funds invested in perhaps only three or four companies.
There are several reasons, then, why investing in a private equity fund in addition to, or in place of, direct investing makes sense:
• Diversification, with a typical private equity fund investing in 10-15 different businesses, across a range of sectors;