Photo: Beryl Elites

Private Equity (PE) and Venture Capital (VC) have been going strong from both strategic and tactical vantage points. They have been outperforming public markets especially on risk-adjusted returns for good reasons, and will likely continue to do so. They also add diversification to a smart portfolio.

From a strategic perspective, according to the panelists at the annual Beryl Elites alternative investment conference, private equity has several unique properties that provide benefits beyond investing in public markets.

1. Private Equity targets are either young companies that have not yet gone public or may never do so or older businesses that have been privately held for a long time such as bespoke family firms. Through the vehicle of Private Equity, these companies gain immediate reach they then apply towards physical output, ongoing innovation, or helpful scrutiny and beneficial adjustments to their business model. They also gain from operating efficiency that PE can add from in-house expertise or its extensive network. New doors open up.

2. The often quite rapid growth that companies experience after Private Equity gets involved advances their financial performance beyond that of public markets. This lowers drawdowns and has historically added alpha through manifest and repeatable mechanisms, hence increasing risk-adjusted returns averaged over time.

3. Private Equity and Venture Capital space are by their very nature less subject to market cycles than public asset classes. They have much longer time horizons, usually 7 to 10 years. This allows subject companies and their venture partners to chart a more fundamental long-run course versus public companies that have to focus instead on quarterly results. An added effect is that the return flows of these vehicles are largely uncorrelated with public markets. This makes them prime candidates for portfolio diversification.

4. The returns of Private Equity and Venture Capital have historically outpaced the returns of public markets at lower volatility. It is here that the added alpha inherent to Private Equity and Venture Capital really shows up. The panelists expect this trend to continue.

A fifth point concerns the opportunity set. There are only some ten thousand publicly listed stocks, but the number of companies that are not listed is very much larger. Hence these are fertile grounds for Private Equity firms to add alpha and create outsize returns. It has even come to the point wherein certain cases Private Equity firms buy companies from other Private Equity firms in order to add their own specialty to the value chain, whether it is instilling operational efficiency, finding or creating new markets, or something else. Opportunities are also increasing as to the depth and variety of Private Equity firms. Over the past six years, the number of Private Equity firms has increased from 6,300 to 9,000, widening the choices for investors.

In the tactical landscape, there are numerous factors in play. The panelists agreed that valuations are a little frothy compared to the last ten years, driven principally by investor demand and the still low cost of capital. According to one panelist, there is some USD 3 Trillion in investable assets looking for a home. This is driving up valuations and multiples everywhere, not just in the venture space. Even so, the panelists noted, the structural factors that separate the Private Equity and Venture Capital venture space from public markets will continue to hold, hence their returns will continue to outpace those markets.

Also, the penetration of institutional investors into this space is still only around 4%. This is bound to increase, hence assuring continued demand and diminishing the chance of a large downturn in valuations. Another source of comfort is that debt-to-equity leverage ratios in this space have been coming down. In 2007 it was around 60/40 whereas now it hovers at 50/50. This fosters stability vis-à-vis the go-go days of dot coms. In addition, the pace of technological change and its impact on producers and consumers alike is accelerating rapidly, giving rise to an ever increasing set of opportunities.

Finally, the quality of offerings has been increasing as the venture space and public markets alike have become sharper. WeWork was presented as an example where markets realized that the emperor had no clothes. Panelists noted its lack of corporate structure and discipline, low barriers to entry, and no technological advantage. They contrasted it with AirBnB, a company with a sustained 40% growth rate driven by tight corporate discipline, 50 to 70% net margin, and much higher barriers to entry.

The last point conveyed to the Beryl Elites audience concerned the notion of sustainable responsible investing, ESG, and good stewardship towards a much wider set of stakeholders than in days past. These encompass, among others, companies’ environmental footprint, the employees themselves, and the larger community. The panelists were happy to note that they saw rapidly increasing emphasis on these aspects to the point that companies that do not pay enough attention now find themselves at a valuation disadvantage in both public and private markets.

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