Alternative Investment  

More flexibility to diversify exposure

This article is part of
Winter Investment Monitor - December 2016

More flexibility to diversify exposure
Average return of investment trusts in the AIC Private Equity sector to December 2 2016

Private equity refers to investments made in non-public companies through privately negotiated transactions. The asset class covers a range of strategies that share a common theme – capital structure optimisation that aligns investors’ interests with management, combined with long-term investment horizons and hands-on management support.

Private equity managers typically specialise in market sectors in which they already have extensive investment experience. They use that expertise to manage assets through economic cycles as well as identify attractive investment opportunities, particularly where they can take advantage of dislocations or mispricing within sectors.

Private equity managers seek to acquire influential or controlling shareholdings in high-quality businesses, at attractive valuations, working closely with a company’s management to implement strategic and operational change to transform a company’s value.

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Better alignment between management and shareholders can be achieved by ensuring that a company’s management are investing at the same time while using leverage to create an efficient capital structure.

Once the value has been unlocked, private equity managers reposition the company for sale at, potentially, a multiple of the invested equity via an initial public offering, sale to a corporate buyer or a secondary sale to another private equity firm. 

The spread of performance in private equity is much wider than in other asset classes and the manager has a significant influence on investment performance.

Private equity covers a range of stages in a company’s development: from venture capital (early-stage/start-up companies) to growth capital (established companies with strong growth characteristics) and buyouts (typically established, cashflow-positive companies with lower volatility of returns and where current ownership is looking to exit). Managers may also invest in mezzanine structures, special situations and real estate.

There are a number of routes into private equity, each with its own opportunities and risks. Generally, capital in the industry is managed in illiquid non-listed structures. Investors may choose to invest directly in a private equity fund, but they are expected to lock in their capital for a long time period – usually 10 years – and many private equity firms will only accept high minimum commitments to their funds.

Investors who prefer to reduce risk through diversification and specialist research may access private equity through a fund of funds – a fund that carefully selects and invests in multiple funds.

This may allow investors greater flexibility to diversify their exposure by type, stage, vintage, geography and sector, thus potentially mitigating the risk of loss from any one manager or company. There are a number of ways fund of fund managers can invest:

l Primaries: New private equity funds that are raised by a private equity manager, often done on a ‘blind pool’ basis, therefore selecting a high-quality and experienced manager is important.

l Secondaries: A purchase of existing interests in private equity funds, typically several years after a fund’s inception. The benefits of investing in secondaries is that the fees and expenses in the first few years have been paid and distributions from the fund will be returned over a shorter time period.