PRIVATE EQUITY INVESTMENT GIVES BETTER EXPECTED RETURNS THAN TRADITIONAL STRATEGIES
This article is the third in a series of seven, exploring private equity investment. It focuses on the return benefits of investing in private equity (only point A in the list below). Points B, C and D will be discussed in the next article.
The main benefits of investing in private equity can be categorised as follows:
- Higher expected returns
- Social and sustainability impact
- The ability to gain exposure to the real South African economy; and
- Diversification benefits (or reducing volatility in a portfolio).
There are many components to the promise of higher returns through investment in private equity. The most useful way of considering expected returns is by understanding human behaviour. Simply put, we don’t like uncertainty, so if we invest in a more risky asset, we require a greater expected return. It does not always pan out as expected, but the rationale must be there. Normal supply and demand forces drive the value of an asset and therefore drive expected returns up or down based on perceived risk (amongst other things).
Private equity should compensate investors for the risk associated with owning a company (fully or partially through owning shares in the company – called the Equity Risk Premium) like any other form of equity. However, in addition, investments in private equity are locked up for up to 10 years, which implies an investor requires a Liquidity Risk Premium. The invested capital also tends to reach smaller companies than what listed equity investments reach most of the time, which is a further driver of expected returns.
What other factors drive higher expected returns in private equity?
- “Management consulting” role played by manager
- Long-term alignment between manager and investor
- Manager selection skill
Management consulting
Private equity firms (called GPs or General Partners) do not simply buy a company that they may consider cheap and then try to sell it at a higher price (as listed equity investors tend to do). Rather, there are a number of strategies employed to extract value – much in the same way as management consultants will tend to enhance strategies of a company. There are strategies such as “buy and build” which increases scale in order to access economies of scale and other benefits, “vertical integration strategies” which aims to capture capabilities along the value chain to create synergies from raw materials to product or service, etc.
There are many other strategies that are employed to extract value, but the point is that these GPs get involved in building these investee companies. Hence you are not simply paying for asset selection (as you would for listed equity mandates), but also for management consulting and involvement. One could think of a part of the fee paid to a GP as a subsidy on the investee company’s management salaries and expenses (or consulting fees). These interventions drive expected returns up, when the GP has skill.
Long-term alignment between manager (GP) and investor
In a fascinating paper by Nick Hudson delivered to the Actuarial Society of South Africa in 2015, “The flourishing firm”, he explains many benefits of the alignment between the GP and the investor –including the fact that the GP is co-investing in the fund; the long term of investment (up to 10 years) and the fact that the GP earns a performance-related fee (called “carried interest”). He contrasts the cost of governance in listed companies, driven by regulations and many “tick-box” based requirements. Yet we have seen massive governance catastrophes.
Nick explains the enlightened investor approach to governance, which is inherent to the private equity industry, in contrast to the listed company model. If management is aligned to long-term value creation and held to account, this drives the need to consider sustainability. He argues strongly for the private equity investment model, and the argument is compelling.
Manager selection skill
The ability to select skilful private equity managers (GPs) is not easy. There are many considerations such as legal knowledge, emotional intelligence and insights required to identify sustainable skill. But the reward (or penalty if you don’t have skill) is clear from the distribution of returns. The chart below shows the annualised returns for the top, median and bottom quartiles as at 31 December 2018 for two distinct investment periods in South Africa.
You don’t want to be playing in the bottom quartile returns space when you are taking on additional risk to invest in private equity. The median return is compelling, but any skill in selecting GPs will be handsomely rewarded for a move towards the top quartile! You are talking about 6% more every year, on average.
There are clearly many sustainable drivers that should continue to benefit investors in private equity, making the investment case for the asset class compelling. Further benefits (and challenges) will be explored in upcoming articles.
Willem le Roux
Principal Investment Consultant and Actuary