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Difficulty: Advanced
Do note that this article is most relevant for Priority/Private Bank clients.
1) What is Private Equity (PE)?
2) What is the optimal allocation to PE?
3) How has PE performed?
4) Why PE has become increasingly relevant
5) How can one get exposure?
InvestQuest: View on the asset class
On Private Equity: Private Equity (PE) has historically outperformed publicly-traded stocks. However, this comes at a cost. First, one needs to lock up money for a long time (lack of liquidity). Second, there’s a high variability in returns between the top and bottom quartile PE Funds. This makes manager selection especially crucial. For accredited investors with longer investment horizons, we think it makes sense to have a PE allocation that is proportionate to the amount of excess liquidity held (i.e. funds which the investor does not expect to touch in the foreseeable future).
InvestQuest: View on getting exposure
On getting PE exposure: Private Banks do offer access to individual PE funds, usually for a minimum of US$250K. Depending on the total amount the client is willing to invest in this asset class, this can result in a lack of diversification between individual funds. As an alternative, several Private Banks do offer a Private Equity Fund of Funds program, which invest in a diversified pool of select PE Funds. They available for investment from as “low” as US$250k. While the fees may be slightly more, IQ thinks that this is an attractive option for high net worth investors who want PE diversification. Through a PE Fund of Funds, investors can potentially benefit from the bank’s expertise in PE manager selection and attain immediate diversification (across PE sub-strategies, geographies and number of deals) in a higher risk asset class.
Disclaimer: The guide below is meant for information purposes only. The information should NOT be relied upon for making any investment or financial decisions. We are also not recommending any particular product. Fees and investment characteristics can vary across Private Equity funds, and so this guide may not be relevant to what is being offered to you.
1) What is Private Equity?
Private Equity (PE) refers to the ownership in an entity that is not publicly listed. This can range from billion-dollar pre-IPO businesses such as Impossible Foods or Ant Financial, to start-ups that have yet to generate any revenues. Private Equity investors tend to be institutional or accredited investors, and they tend to hold on to their investments for much longer.
In contrast, Public Equity (i.e. the stock market) is available for anyone to invest at anytime.
Private Equity is a very broad term, which is why it is important for investors to differentiate between its different categories to know exactly what they are investing in. We have summarized the different categories in the below table, providing a very brief explanation for each, with accompanying examples of PE Fund Managers which are known to specialize within those categories.
A few features that are common across the different PE categories are:
- Long investment term: Most PE Funds have a fund term of approximately 10 years.
- Illiquid: There is no active market to sell your stake in a PE investment immediately.
- High execution risk: Investment success will depend on the company management’s execution of corporate strategy amid other macro factors.
- J-Curve Effect: Capital will be called during the initial years of a PE Fund investment and it may take some time before capital and profits are distributed back to the investor. You can read more here.
2) What is the Optimal Allocation to PE?
Institutional investors with very long investment horizons have been the main source of Private Equity capital. The chart below shows the current average portfolio allocation to Private Equity, by investor type.
Entities with the longest (and sometimes indefinite) investment horizons and highest investment risk tolerance such as Family Offices, Sovereign Wealth Funds, Endowments and Foundations currently allocate more than 10% of their portfolio to Private Equity on average.
On the other spectrum, individual investors (Accredited and Retail) have the lowest allocation to PE at <1%. Although most Private Banks advocate 20-30% asset allocation to Alternative Investments (Hedge Funds, Private Equity, Commodities), PE investments have still been outside the comfort zone of many high net worth individuals.
Over time, we can expect investors’ allocation to PE to continue to rise, as approximately half of institutional investors surveyed by Bain & Company are still under-allocated to PE, relative to their own target allocations as of end-2019 (chart below).
The InvestQuest’s View on PE allocation: The ideal PE allocation for a high net worth individual depends on several factors, ranging from expected liquidity needs (which influences an investor’s investment horizon) and investment sophistication of the investor. Given that we don’t have big ticket expenses planned, IQ is personally comfortable with having 10-15% of our portfolio invested to Private Equity, preferably in a diversified manner.
3A) How has Private Equity performed historically?
Private Equity has been sought after by investors due to its ability to outperform traditional asset classes such as publicly-traded stocks and bonds, over long investment horizons.
The chart below shows the Net Internal Rate of Return (IRR) for PE Funds, across Vintage Years starting from 1995. We have plotted the median, lower quartile (25th percentile) and upper quartile (75th percentile) net IRR returns for reference.
What’s net IRR? In very simplistic terms, you can think of net IRR as the annualized performance of an investment, adjusted for the timing of when capital was deployed and distributed. Naturally, the higher the IRR, the better for investors.
A Vintage Year indicates the year a Private Equity Fund was launched. For example, the median net IRR for Vintage Year 1995 is 11%, which means that if you pooled all the PE Funds launched in 1995, they would have generated an 11% net IRR.
Note 1: PE returns are based on data compiled from 2,059 private equity funds, including fully liquidated partnerships, formed between 1995 and 2018. Internal rates of returns are net of fees, expenses and carried interest.
We have two major takeaways from the above chart.
Takeaway 1: PE Funds offered a very attractive 13% net IRR on average, for Vintage Years 1995 to 2016. We have deliberately excluded Vintage 2017 and 2018, as PE Funds launched that recently are likely still in the capital deployment phase and do not provide a meaningful performance statistic.
Takeaway 2: The returns of top-performing and bottom-performing PE Funds vary widely. If we compare the net IRRs for PE funds ranked in the upper quartile (75th percentile) and lower quartile (25th percentile), the difference is a staggering 15% difference on average, for Vintage Years 1995 to 2016. This means that manager selection for PE investments is extremely vital!
3B) How has Private Equity performed relative to Public Market Equities?
The chart below compares the IRR of Private Equity vs. the Public Equity Equivalent, organized by vintage year of the PE fund. To derive the Public Equity Equivalent IRR, it is assumed that shares of the global equity index was purchased and sold according to the PE Funds’ cash flow schedule.
- Red Line: Net IRR of Private Equity Funds
- Black Line: Net IRR of Public Equity Equivalent
- Shaded in grey: Difference between Private Equity and Public Equity IRRs. A positive value would indicate that Private Equity had outperformed Public Equities in that Vintage Year, and vice versa.
A key observation from the chart below is that Private Equity has outperformed Public Equities in each Vintage Year from 1995 to 2016. This outperformance has ranged between 2% to 14%, and averaging at 7%. These figures are on an annualized basis, which makes it very significant. We have deliberately excluded Vintage 2017 and 2018 from the figures quoted, due to reasons mentioned earlier.
Note 1: PE IRR is based on data compiled from 2,059 private equity funds, including fully liquidated partnerships, formed between 1995 and 2018. Internal rates of returns are net of fees, expenses and carried interest.
Note 2: Public Equity IRR is computed using a Modified Public Market Equivalent (MPME) methodology on MSCI All Country World Index. The Index shares are assumed to be purchased and sold according to the PE Funds cash flow schedule to derive the public-market equivalent return.
We do have to remember that the higher relative returns from PE come at a “cost” – one has to lock up capital for a long time. PE investments tend to be illiquid, since you can’t sell shares of a Private Company as easily as you would for Public Company shares. As a result, we should think of the higher PE returns as being a compensation for taking on the liquidity risk.
4) Why PE has become increasingly relevant
REASON 1: Decline in public market opportunities
We have been seeing a decline in the total number of listed companies in the past decade for a number of developed nations. A classic example would be the Wilshire 5000 Total Market Index in the US, which despite its name, currently only holds around 3,500 stocks (the last time the Index held 5000 or more stocks was in 2005!). We can see from the chart below that the number of listed US companies has declined by close to 50% in the past two decades!
Looking to our home market (Singapore), the trend is similar. According to a CNA article published in March 2020, SGX has witnessed net delistings in seven of the last nine years, with the number of listed companies decreasing from 783 in 2010 to 723 in 2019.
Separately, we have been seeing an increasing number of private companies choosing to remain private and/or hold off their IPOs till the business has reached a much more mature stage. In such a scenario, the realization of value created by such companies will be enjoyed by Private Equity investors rather than publicly-listed stock investors.
REASON 2: Access to certain markets
In emerging market countries where capital markets are relative nascent, many businesses are still held privately. This is evident when we look at the publicly-listed stock market capitalization to GDP across various countries. In the below chart, we see that emerging market countries such as China, India and Brazil tend to have lower ratios compared to developed countries like US, Japan or Singapore.
Private Equity may offer access to certain opportunities in these high growth emerging markets that cannot be found in the stock markets.
5) How can one get exposure to PE?
There are a few ways to invest in PE, which I have listed in the table below. Do note that information below is very generalized and the actual investment terms of specific vehicles may vary widely.
For high net worth investors, one way to get PE exposure is via a Private Bank. The minimum investment size to access top tier PE Funds directly can range from US$5mm to US$25mm, putting it out of reach for many investors. However, Private Banks are able to pool the demand across their client base, offering access to these select PE Funds for as “low” as US$250k.
In recent years, several Private Banks have offer close-ended funds that invest in a diversified pool of 8-12 select PE Funds, available for investment from US$250k. I think that this is an attractive option for high net worth investors, who can benefit from the bank’s expertise in PE manager selection and attain immediate diversification (across PE sub-strategies, geographies and number of deals) in a higher risk asset class. The Private Banks we know that have such programs include:
- J.P. Morgan Vintage Program
- HSBC Vision Fund (not to be confused with Softbank’s Vision Fund)
- Citi Collections
- UBS Multi-Vintage PE (MVPE)
- Credit Suisse Seasons Global
- Julius Baer Private Equity Vintage Program
Separately, while I am less familiar with the Angel Investing scene, a local finance site DR Wealth has recently written a introductory article on it (click to see that article). Investments in start-ups entail a much higher level of risk, so do thread carefully and manage the bite size of such investments accordingly. Angel investing is sometimes conducted on an informal basis – we want to highlight that there are risks to this. It’s always better to get a lawyer to draft a contract that protects you from unforeseen liabilities and from fraud.
InvestQuest: View on PE as an asset class
On Private Equity: Private Equity (PE) has historically outperformed publicly-traded stocks. However, this comes at a cost. First, one needs to lock up money for a long time (lack of liquidity). Second, there’s a high variability in returns between the top and bottom quartile PE Funds. This makes manager selection especially crucial. For accredited investors with longer investment horizons, we think it makes sense to have a PE allocation that is proportionate to the amount of excess liquidity held (i.e. funds which the investor does not expect to touch in the foreseeable future).
InvestQuest: View on getting PE exposure
On getting PE exposure: Private Banks do offer access to individual PE funds, usually for a minimum of US$250K. Depending on the total amount the client is willing to invest in this asset class, this can result in a lack of diversification between individual funds. As an alternative, several Private Banks do offer a Private Equity Fund of Funds program, which invest in a diversified pool of select PE Funds. They available for investment from as “low” as US$250k. While the fees may be slightly more, IQ thinks that this is an attractive option for high net worth investors who want PE diversification. Through a PE Fund of Funds, investors can potentially benefit from the bank’s expertise in PE manager selection and attain immediate diversification (across PE sub-strategies, geographies and number of deals) in a higher risk asset class.
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