These are negotiated investments in privately held companies at different stages of maturity undertaken with the objective of improving their profitability and growth prospects and then reselling them at a higher price in the future. Private equity fund managers often have increased access to information regarding their investments, while traditional money managers must rely on publicly-available information, because they only invest in the public markets. Also, private equity managers often invest based on a negotiated price, while traditional money managers typically pay market prices. They often create value and are able to exit acquisitions at higher multiples thus creating a profit for their investors.
Private equity is an extremely heterogeneous asset class with many sub-sectors. These sub-sectors, some of which we discuss below, have very different asset characteristics. This means that each subsector has different performance drivers, which investors need to understand to make informed decisions.
- Venture Capital: These firms provide risk capital for starting, expanding and acquiring companies. Most are quite specialized, often investing in a single field, such as telecommunications or health care. Venture capital firms also tend to specialize by investment stage. These funds generally do not offer any income but have a high capital gain (but also very high risk) returns potential.
- Leveraged Buyouts: Leveraged buyout firms specialize in financing the purchase of established mature companies that are generating cash-flow (used to service the debt). Investing in these funds allows directionally long exposure to equity.
- Mezzanine Capital: These funds provide an intermediate level of financing in leveraged buyouts below the senior debt layer and above the equity layer. A typical mezzanine investment includes a loan to the borrower, in addition to the borrower's issuance of equity in the form of warrants, common stock, preferred stock, or some other equity investment. These investments provide returns through income and sometimes offer capital gain potential through equity warrants.
- Distressed Investing: This includes i) the purchase of companies that are distressed or out of favor, for low multiples of cash flow and/or low percentages of asset value; or, ii) the acquisition of quality companies with excessive leverage or those that are going through bankruptcy that require restructuring. Distressed security returns are a combination of the risk premium from holding low-grade securities and the illiquidity premium from holding less liquid securities. Distressed securities are usually considered risky because there is a distinct possibility that the company might not recover. If that happens, an investor may lose part or even all of invested capital. A variant of distressed investing is Special Situations investing . This is a broad category which encompasses variations of opportunistic distressed investing, equity-linked debt conversion plays, project finance, as well as one-time opportunities resulting from changing industry trends or government regulations.
Private equity can be a source of attractive returns over the long term. Moreover, private equity returns do not correlate closely with returns from traditional asset classes - properly implemented, the introduction of private equity can improve portfolio diversification.. They have the potential to provide access to selected growth opportunities even in low macroeconomic growth environments for successful private equity managers are focused on picking companies with growth potential and actively creating conditions for growth, which investors can monetize. They are however long-term oriented illiquid investments. Interests in private equity funds are generally not readily marketable, transferable or redeemable. They have uncertain cash flows with respect to both capital calls and distributions. Also, they are a form of blind pool investing, since investors do not know beforehand what their funds will be invested in and must rely on the skills and judgment of the private equity manager. Private equity is heterogeneous and includes several sub-sectors, all of which have their own unique characteristics. Given large dispersion of returns across managers and a degree of performance persistence, manager selection is of critical importance.
Please continue to check back in the coming weeks as I will be diving deeper into durable income-producing alternative investments.