Private wealth and private equity – does private equity remain a private affair?
Asset managers should heed millennials' investment convictions, according to The Economist (Millennials and markets - In defence of millennial investors | Leaders | The Economist). But how do they invest? According to our report 'Millennials money & myths', surprisingly or not, the second highest source of millennials' wealth is from investment products, with traditional investment in shares and stocks being among the most popular.
Hence it remains the case that for millennial and general retail investors alike, buying shares or funds listed on the London Stock Exchange's Main Market, or, the London Growth Market, AIM, is the main way to invest.
In contrast, however, professional investors are increasingly looking at alternative asset classes in their search for ever elusive gains, turning frequently to private capital. One asset class that particularly stands out is private equity. Yet it is frequently not on the radar for many retail investors.
This article looks at some ways in which retail investors can gain exposure to private equity.
Why investors are looking at private equity?
Although still considered an alternative asset class, private equity has very much evolved into a source of finance in its own right. While achieving above average investment performance has become increasingly difficult in traditional asset classes, private equity investment has arguably shown a propensity to achieve above average returns. As an added benefit, as some have noted, it can diversify a portfolio away from the vicissitudes and arguable short-termism of public markets (though perhaps at the added risk of leverage).
The notable rise of private equity has been attributed to several, somewhat related, factors. Primarily ultra-low interest rates have pushed investors into risker but potentially higher-yielding illiquid asset classes, such as private equity.
These low interest rates have also reduced the cost of debt used by private equity funds when buying their portfolio companies making it cheaper and easier to do so, but with the added risk of high debt levels when interest rates rise, which some commentators consider likely. Equally, high levels of 'dry powder' currently at the disposal of private equity firms has given them the firepower to launch bids to acquire large public companies, marking a return to the fabled 'take-private' deal. Indeed, some of the most innovative businesses, from tech start-ups to so-called unicorn businesses, are choosing to forgo a public listing and stay private. This has resulted in fewer companies being listed. All these factors have been attributed to the growing ascendancy of private equity.
Indeed, as Scottish Mortgage Investment Trust PLC managed by Baillie Gifford, one of the best performing long-term investors which has traditionally favoured listed equity investment, remarked:
"[w]e are convinced that the long term risk taking, essential to economic and social progress, is continuing to migrate to private markets and at an accelerating pace."
But what is private equity investing?
The premise is simple: investing in unquoted and unlisted private companies. However, a general distinction has emerged in private company investment. The term private equity typically refers to investments by a private fund, managed by professional investment managers, which invests in medium to large private companies often taking a large majority stake with significant bank borrowing filling the funding gap. Whereas venture capital investment is the term given to, also professionally managed, smaller investments often without debt financing, usually subscribing for shares as opposed to buying them from existing shareholders.
Why can't retail investors access private equity?
This is an issue for retail investors. Whilst it is easy for retail investors to buy shares in listed companies, the same cannot be said about private companies (and the private equity funds that specialise in investing in private companies). Considerable legal, regulatory and economic hurdles inhibit retail investor's ability to access private equity.
To invest in a private equity fund, one must able to commit a large sum of money into a totally illiquid asset. Since shares in private companies are not traded on a stock exchange, there is no readily available secondary market on which to sell shares. In terms of commitments, for medium to large sized funds, this is typically five to ten years and around £10 million investment (albeit, some smaller funds may have a minimum commitment of £500,000, slightly above one's £20,000 ISA allowance).
To touch on some of the legal barriers, one of the most subtle yet significant restrictions on UK companies is tucked away in section 755 of the Companies Act 2006. Under this section, a private company "cannot offer its shares to the public unless the offer is not calculated to result, directly or indirectly, in shares of the company becoming available to anyone other than those receiving the offer" (or the offer is otherwise a private concern of the person receiving it and the person making it).
Incredibly strict regulation also applies to promoting investments in private companies and private funds. The Financial Services and Markets Act 2000 makes it a criminal offence for any person other than an authorised person to 'communicate an invitation or inducement to engage in investment activity' unless its contents have been approved by an authorised person or meets an exemption. Additionally, when making an offer to subscribe for shares to the public, the company may need to produce a prospectus, which is a costly and time consuming ordeal.
Similarly, private companies' articles of association frequently impose stringent restrictions on the ability to transfer shares and often have esoteric technical features contained in different classes of share, resulting in one being required to instruct a lawyer to weed through the technical detail in order to discern a holistic picture of the company's legal structure. In addition, the lack of disclosure obligations and legal protection afforded to shareholders in private companies necessitates substantial (and costly) financial and legal due diligence and legal documentation to overcome the inherent information asymmetry, as financial economists call it, between buyer and seller of shares in private companies.
Consequently, private companies often choose not to issue shares to the public, instead habitually relying on investment from venture capital, private equity and banks. Some sophisticated private investors, angels, do invest in very companies, but their risks are substantially mitigated through tax breaks.
For these reasons (and many more), private equity has historically been the preserve of large, specialist institutional investors, family offices and wealthy individuals.
Distractive features of private equity
The business model of private equity is very much based on a small shareholder base – simply the private equity investor (or sometimes a couple of investors) and the management team of a private company. This makes it unnecessary to raise funds from the general public. Most typical private equity transactions aim to take a majority, controlling stake (often 75%+ of the share capital) with debt finance raised from banks and finance institutions privately to add financing risk to the inherent business risk of the business being acquired which increases the potential returns on the equity (assuming the debt can be serviced) substantially.
In contrasts, listed companies can have a diverse and disparate shareholder base. This may give rise to the so-called 'free-loader effect', i.e. shareholders expect (particularly if their shareholding is minor) other shareholders to ensure management is running the company properly, with a potential consequence being that no-one is incentivised to monitor and challenge management. It is easier to sell a publicly listed share if you don't like the way the company is managed than to change the management. This is nothing new. Indeed, as Adam Smith remarked back in the 18th Century, where there is no 'spirit of faction' between shareholders in joint-stock companies (the ancestor of modern companies) with shareholders merely expecting their habitual dividend, there is chance that directors will not manage shareholders' interests with the same 'anxious vigilance' as they would their own. Private equity-backed companies are very unlikely to become sinecure 'life-style' vehicles of management (which critics argue may be more likely in public companies). This is because private equity funds arguably do a better job of monitoring management and aligning managements' interests with theirs, primarily due to their large majority-stake commitments, the concentrated incentive packages given to management and control rights under their legal documents.
Listed private equity investment trusts
However, there is a way for retail investors to access private equity.
Listed private equity is an easy way to access gains from private equity investing. On first sight, speaking of listed private equity seems oxymoronic, but there are now many listed funds that specialise in investing in private equity, thereby making them easily accessible by retail investors. One of the earliest examples being 3i which has been a private equity investor since the 1940s, when it was set up with government backing by the big commercial banks, and listed in 1994.
In short, a listed private equity fund is not unlike any other listed investment fund that invests in companies. But, rather than investing in listed shares of companies (or other listed funds), they exclusively invest in private markets by investing directly in private companies and indirectly through private equity funds (or a combination of those). That being said, as alluded to above, many general investment trusts, such as those managed by Baillie Gifford, now frequently invest in both public and private equities (but unless structured appropriately this comes with risks).
Almost all private equity-specialised funds that are listed on the London Stock Exchange are constituted as investment trusts. Despite the name, investment trusts are not trusts in the legal sense, but companies. Like any other publicly listed company, the shares in the investment trust are listed and traded on a stock exchange. Consequently, there is a readily available secondary market on which to sell the shares, overcoming the inherent illiquid nature of traditional private funds and companies mentioned above.
In contrast to other types of retail funds, as shares in investment trusts are not redeemed rather sold on a secondary market, the directors of the investment trust are not occupied by daily redemptions of open ended funds (the potential extreme consequences of which was shown by the Woodford debacle).
As an added benefit for retail investors, shares in an investment trust specialising in private equity, may be held in an ISA. In contrast, direct investment in shares in private companies and private funds cannot. No large commitment is require either.
One general difference from a listed PE-fund and a traditional private equity fund is the way in which returns are realised by the investors. In a traditional private PE fund, returns are commonly realised by gains from capital distributions, whereas in a listed PE vehicle (as they are not finite in duration as with normal PE funds) investors realise their gains through share price appreciation and dividends. Another distinction is that a listed PE fund has greater flexibility to reinvest gains made through exited investments into new investments.
The main investment styles of a listed private equity investment vehicle are:
- direct investment – the fund will acquire shares directly in the private company.
- 'Fund of funds' – where the listed vehicle invest in unlisted traditional PE funds.
- co-investments – where a listed PE fund already invested into an unlisted PE fund invests directly alongside that fund.
- providing debt financing to private equity transactions.
Invest in the private equity managers themselves
One criticism of private equity is the high fees and profits made by the managers of the funds. If you think this is true then there is an answer: buy shares in the private equity managers themselves. In fact, some of the biggest private equity funds are now listed on public markets and therefore accessible by retail investors.
Though perhaps not applicable for all retail investors, certain wealthier individuals may consider investing directly into private companies without going through a financial manager, such investors usually being referred to as business angels. Business angels are individuals who invest primarily in the equity of small entrepreneurial companies and can provide advice and connections to the start-up. Sometimes such investors form syndicates and invest alongside each other. There are also now investment platforms that allow retails investors to invest in early-stage private companies. There may also be quite generous tax benefits if qualifying as Enterprise Investment Scheme or Seed Enterprise Investment Scheme.
Private equity offers potentially strong gains and diversification, making it an increasingly interesting area of finance; however just because an investment has performed well, doesn’t mean it will continue to do so. Indeed, as Scottish philosopher David Hume pointed out, it is fallacious logic to assume that the future will resemble the past, as the FCA reminds us today about financial managers' performance.
Although private equity is still primarily a private affair, there are various routes through which retail investors can access private equity for relatively small sums. The rewards can be handsome, but with all investing there is no such thing as a free lunch.
This article is for information purposes only and is not a substitute for legal advice and should not be relied upon as such. Please contact Rory Swanson to discuss any issues you are facing.