Why invest in private equity?
Invest with actual impact
Private equity strategies can be a much more effective way to have true impact with your capital than buying publicly listed stocks. To understand this better let’s understand what impact really means.
To have impact as an investor, your investment should create change in the real world. To affect real world change an investment should meet two criteria. First - something needs to change in the real world as a result of your investment. Secondly - your impact needs to be additional - meaning it would not have happened if you had not made such investment. Let’s explore these further by means of an example.
What changes in the real world?
Let’s start with the example of buying EUR 50.000 worth of shares in Tesla on the stock market. What changes in the real world when you buy these shares? Does Tesla produce more cars or better cars? As explained above, typically when you buy shares in the stock market - you buy shares from someone else. So no additional capital actually went into the company. Hence - nothing immediately changes in the real world*.
*Provided enough people buy Tesla shares. If so, the stock price goes up and it becomes cheaper for the company to raise capital by issuing new shares (i.e. they have to issue fewer shares to raise the same amount of money), and therefore it is an indirect effect. But this effect is very small for the individual investor.
How about additionality?
There are two ways to think about additionality here. First - what would have happened if you had not bought those shares? Second - what alternative sources of financing does the company have? Given that public markets are highly efficient markets - the probability that someone else would have bought the shares - if you had not - is very high. Secondly - rather than issuing new shares in a public offering, Tesla could also get ample bank loans or other forms of financing. So the level of additionality is low.
Real world change & additionality in private markets
When you invest in private markets - especially in venture capital and growth equity you provide fresh capital to the company that is directly invested in R&D, product development, growth through sales and marketing efforts or growing the team. There is a direct link between capital invested and output. Venture capital and private equity funds furthermore typically pursue an active value creation strategy by providing hands-on support in addition to providing capital.
Secondly because private markets are less efficient additionality is a lot higher. Startups and scaleups particularly have few, if any, other sources of funding than venture capital and growth equity.
Diversify your portfolio
Diversification in investing is an investment strategy that helps lower the risk of your portfolio and generate more stable returns. Private equity offers a great way to diversify your portfolio for several reasons.
Access a substantially larger investment universe
The vast majority of companies in the world are private. In the US there were approximately 7 million* companies with employees of which 1.9 million have 50 employees or more in 2021. Meanwhile there are only around 4.000 companies listed on the stock exchange in the US*. This number has consistently been declining over the past decades as companies opt to stay private longer. As a result private investors are missing out on a huge share of the investment universe and all of the value creation opportunity in private markets.
Lower correlation risk
Diversification can be achieved by investing in a large number of companies (or stocks) and/or by investing across multiple asset classes. Diversification works best when assets are uncorrelated or negatively correlated with one another, so that as some parts of the portfolio fall, others rise*.
Long term perspective
- Private markets are often lauded as being excellent portfolio diversifiers for investors seeking alternative drivers of risk and return
- Lastly, investments in private equity funds force investors to take a long-term perspective, avoiding tactical and behavioral errors
- Modern portfolio theory tells us that we should reduce business and financial risk as much as possible through diversification, which is best achieved by selecting assets that have low correlation with each other. Private equity can help to diversify a portfolio by mitigating both public market risk and cyclical risk.
- It’s widely known these days that diversification is crucial to reduce risk in an investment portfolio. Professional investors diversify their portfolio by investing in several assets classes (public equity, private equity, bonds, etc.), as well as within asset classes (multiple strategies and funds)
Realize superior returns
Private equity has outperformed the public markets by a significant range over a long period of time. Venture capital is within the broader private equity market a strong outperformer as shown by below graph.
Value creation drives the returns
Private equity funds are able to continuously outperform public markets by adding value to their portfolio companies, warranting a high price at exit. Private equity funds are structured to optimize value through a variety of levers:
- Attract and retain the best people. Some of the most clever people work in private equity industry
- Proven playbook driving repeated success. Private equity funds typically deploy a number of proven strategies to add value to their investment portfolio. Strategies include: operational improvement, team building, buy-and-build, multiple expansion, and deleveraging
- Patient capital. Private Equity companies are not listed on the stock exchange and therefore less preoccupied with quarterly growth numbers. The investment horizon of a typical private equity fund is 4 to 7 years, creating ample time to invest in long-term value creation (rather than managing quarterly analyst expectations on the stock exchange)
- Strong alignment of interest with investors (LPs). There are strong incentives in place to maximize value for the investors in a private equity fund. In a typical private equity fund, the fund manager is entitled to 20% of the profits after they have returned capital to their investors