Private Equity

Today’s investors have multiple options when it comes to investments. Many have shifted their mindset to “passive” funds. These are a form of public equity, where publicly available stocks are easily bought or sold, have low fees, and can be run by a computer.

Private equity, on the other hand, is an investment of capital into private companies. The capital enters a private market that offers sparsely traded, higher fee assets that are not listed on public exchanges and are run by humans.

Market size of Global Private vs Public Equity

More money is being put into the private sector. The amount of public companies in the United States has dropped by over 30% since the 1990’s. However, public companies’ market capitalization (USD $70 trillion) is still significantly larger than that of private companies (USD $7 trillion). Capital is more easily accessible nowadays from various private entities. This private capital is supposed to help reduce “agency” conflicts that may arise, such as when shareholders in a public company do not have enough shares to influence the decisions of the large company’s managers.

Private capital is often doled out to unlisted startups in Silicon Valley that hope to become unicorns (think Facebook, Microsoft, or Amazon). Today’s tech firms have more value tied up in new ideas than in current assets. These new “idea firms” are a better fit for private capital than for the public market. The expectation is that these startups are being overseen by a few managers from the investment company, allowing for a more intimate management structure without the public scrutiny.

While private equity is seen as an exciting investment option with potentially huge returns, there are various pros and cons that people should be mindful of.

Advantages of Private Equity

One advantage of private equity is that it is seen to have more knowledge among its managers, most of whom are highly skilled investors. Private equity funds have been shown to increase both efficiency and revenue, and the private funds also allow for a long-term approach. Many private investors keep their money tied up in an investment for up to ten years, exercising patience while allowing the company to grow into a profitable machine, an “illiquidity premium”.

Investors may face limitations on how much they can borrow. Private equity offers a way round such constraints: it is liberal in its use of debt to juice up returns. The value of privately held assets are not assessed all that often. That is a plus for those who do not like to see how volatile their investments are.

A recent study by Steven Kaplan, Robert Harris, and Tim Jenkinson 2015 (Journal of Investment Management), found that private venture funds beat the S&P 500 returns by 3% annually after fees from 1984 to 2005. However, they have matched public equity returns since 2006.

Disadvantages of Private Equity

There’s growing concern that the “agency” conflicts that are supposed to be reduced in private equity actually still exist. Some argue that the conflicting decisions made by managers in large, public companies have just been replaced by the egos of managers in the venture-capital world.

Also, private equity often lacks transparency and liquidity. Data is hard to gather in the private sector, which makes asset appraisals difficult. Until a private fund is liquidated, those funds can operate with unseen discretion, allowing assets and metrics to value performance in a “generous” way, Brown et al. 2017 (Journal of Financial Economics).

It has been argued that these self-appraisals benefit the managers of private-equity funds, allowing them to operate with more leverage to achieve the greatest returns. Diversification benefits of private equity investments are overrated. When liquidity is taken into account, the risk-adjusted excess return “alpha” of the asset class is almost zero, Franzoni et al. 2012 (Journal of Finance).

While the public markets are quite liquid, the private market eschews that liquidity in favor of promising better returns. While private firms are afforded more time from patient investors, there will always be demand for more liquid cash. When the public market offers a buying opportunity during a down period, non-liquid assets can’t be as easily sold to engage on this market advantage.

Overall, there’s nothing wrong about wanting to invest in private companies. Just be aware of the various pros and cons, fees, be very well-diversified, and size your investments according to the market size and risk.