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The excellent track record of Private Equity and the search for returns are behind the current growing interest from private investors. Jerôme Zahnen, Investment Advisor at the Banque de Luxembourg, reviews this asset class in an article published in the latest Luxemburger Wort supplement on investment funds.
Investing in private equity allows you to participate in the capital of unlisted companies through private transactions. The goal is to actively finance and influence their development with a view to reselling the stake within a three to eight-year year timeframe once the investment objective has been reached. Investments in Private Equity are therefore intrinsically more long term than traditional investments on the financial markets. The underlying companies thus have the opportunity to implement longer-term strategies, without the short-term pressures common to many listed companies that are obliged to publish quarterly results.
What are the most common strategies?
Among the various Private Equity strategies, these are the three main ones:
- Venture Capital strategies invest in companies that are at an early point of the development cycle, such as start-ups, which have high growth potential but also high risk.
- Growth Capital strategies target more mature companies, helping them to expand and develop. Generally, investors take a minority stake in this particular strategy.
- Lastly, Buyout strategies targets established companies, generating more constant and predictable cash flows. By financing their expansion, through targeted acquisitions for example, investors can count on a more reliable performance. Historically, the Buyout strategy offers the most attractive risk/return profile within Private Equity.
Why invest in Private Equity, and more specifically in a Buyout strategy?
The main reason is obviously the attractive expected returns. Over the long term, Private Equity has in fact out-performed the public market. The Buyout strategy in particular has shown greater resilience during the recent recessions. Unlisted companies are only revalued on a quarterly basis, enabling them to avoid succumbing to the winds of panic that sometimes blow through the stock markets.
In general, there are three value-creation mechanisms for underlying companies: operational improvements, debt reduction and expanding multiples. Operational improvements consist of, for example, reducing costs or reorganising the business. As the Buyout strategy is in part financed by leverage, the use of cash flow to repay debt also contributes to performance. Lastly, expanding multiples means selling a stake in a company for a higher price than the purchase price.
Who should invest in Private Equity?
Historically, the majority of investors in Private Equity were institutional investors, with the amounts invested reaching several million euros. The excellent track record of Private Equity and the search for returns are behind the current growing interest from private investors for this asset class. The SEC, the US financial regulator, is studying the possibility of facilitating access to Private Equity for private investors. However, this asset class is only of interest to investors with a sufficiently long-term investment horizon. On average, the term of a Private Equity fund is between 10 and 12 years. The first five years are the investment period during which the amounts committed are gradually called up in order to finance acquisition of the targets that will make up the portfolio. After this period and in a gradual manner, the investor will benefit from return on capital as companies are resold.
How has the Private Equity industry developed?
Driven by excellent performance, the industry has seen strong growth over the last decade. Originally, debt reduction was the main contributor to performance for the Buyout strategy. Today, performance is driven more by operational improvements. In this context, companies are increasingly calling on Private Equity funds as long-term strategic partners.
What do you need to consider when planning an investment in Private Equity?
Selecting the right general partner – i.e. fund manager – is vital. We have observed significant disparities between the returns from general partners and the consistency in their individual performances. In other words, the best Private Equity fund managers generally succeed in replicating their good results by consistently reporting notably fewer write-offs. Therefore, as an investor, it is crucial to undertake serious due diligence regarding the different Private Equity funds in order to identify the best managers. In an environment where company valuations are bullish and the level of liquidity reserve (dry powder) to be deployed is very high, having the experience of a quality fund manager on your side is advisable. It is also important to choose a prudent manager who has access to exclusive transactions through their network, and who applies tailored value-creation strategies to each transaction.
How much money does an investor need to access Private Equity funds?
Many Private Equity funds require a minimum investment of several million euros; few private investors can access them directly. To meet rising demand, financial institutions – in particular private banks – have established structures (feeder funds) to combine the commitments of several investors in order to invest directly in the fund(s) selected. Furthermore, investors benefit from an analysis conducted by a qualified team of managers when selecting funds. Banque de Luxembourg has had such a Private Equity fund for several years already and is currently offering a sub-fund for the Buyout strategy focusing on Europe.