The Benefits of Private Equity Investment
Published September 10, 2013
Twitter and Pinterest—two privately held companies celebrated for their innovation, user connections and distinctive appeal—have enriched a growing number of lives in the global economy. The founders of companies like these are generally unable to rely on traditional sources of funding. An alternative source of capital—private equity—is provided by a patient and stable base of long-term institutional investors, such as public and private pension plans, corporations, family offices, endowments and charitable foundations. These diverse providers of long-term capital allow companies' management the time to execute strategic business plans. They are also afforded the opportunity to sustainably grow the equity value without the scrutiny of Wall Street and public shareholders, who are not typically as patient as long-term investors.
Private equity represents an increasing component of overall asset allocation among institutional investors. In comparison to a traditional portfolio of investments (e.g., stocks, bonds and cash equivalents), investors expect to generate highly attractive returns for their stakeholders—public, corporate, union and church participants. While private equity investing as an asset class has existed since the mid-20th century, it has grown exponentially over the past two decades, reaching a peak in 2007 with $550 billion raised globally, according to Thomson ONE, the research arm of Thomson Financial.
Private Equity Offers Lower Volatility
All investing activity involves a degree of risk. However, private equity investors accept an additional element of risk because these investments are typically illiquid—meaning investors cannot withdraw their invested capital whenever they choose. For example, it took Google and Facebook six and eight years, respectively, to execute an initial public offering (IPO). That marked the first opportunity for private equity investors to sell their shares on a public exchange and realize the earnings on their invested capital. However, while private equity valuations tend to directionally track the public markets over time, the value of these investments is not subject to the excessive volatility frequently experienced in the public equity markets. Accordingly, the relative stability of returns for these types of investments provides an important element of diversification for multi-asset institutional investors.
Wespath Benefits and Investments (Wespath) began investing in private equity in 2003 to help diversify the U.S. Equity Fund's (USEF) risk/return profile. Private equity investments are channeled through a limited partnership arrangement known as a "fund-of-funds" (or manager-of-managers). The general partner of these capital pools performs the required due diligence prior to making commitments to suitable private equity funds. Highly sophisticated investment firms manage these funds with teams of specialists that possess the experience, knowledge and vision needed to identify successful private equity opportunities.
Fund-of-Funds Approach Improves Diversification
Wespath's fund-of-funds approach to private equity provides diversification in two ways. First, private equity incorporates two diverse strategies:
- Leveraged buyouts (LBOs), where well-established and publicly-traded companies are acquired and converted to private ownership. The purchase price is financed through a combination of private equity and debt, and corporate governance is typically improved, resulting in operational efficiencies and higher earnings growth.
- Venture capital investments in typically early-stage or even start-up firms that emphasize revenue growth and have a specific focus in rapidly growing industries, such as social media, computer software and biotechnology.
Second, Wespath's fund-of-funds approach to private equity provides diversification across general partners and industries. Currently, Wespath invests in more than 1,000 companies through its private equity portfolio.
Private Equity Adds Value to U.S. Equity Fund Performance
While it may be many years before Wespath is able to withdraw capital from many investments in its private equity portfolio, the performance of these investments to date demonstrate the benefits of private equity investing. Using a five-year horizon from July 1, 2007 to June 30, 2012, Wespath's private equity portfolio had an annualized internal rate of return of 4.2%. While we expect significantly better results from our private equity investments over the long term, this rate of return is significantly better than the 0.4% return achieved by the Russell 3000 Index (the benchmark used to evaluate the performance of USEF). The private equity funds in which Wespath has invested are at least five years from full liquidation, so returns will likely vary from these interim results.
In addition to its comparative advantage in the rate of return, an internal study found that Wespath's investments in private equity improved diversification by reducing the overall risk of the fund relative to the Russell 3000 Index. Wespath is committed to a broadly diversified investment program and believes that private equity will continue to be a diversifying asset class and beneficial component to a prudent, long-term investment strategy.