Private Equity Firms – What Do They Do?

The financial media and most investors focus on investing in publicly-traded companies. “Publicly-traded” means the companies’ shares can be bought and sold in the stock market. As I indicated in a previous post: Stock Analysis: Value Stocks vs. Growth Stocks, only 3,700 companies (stocks) trade on a stock exchange in the United States and another 15,000 or so are public but trade over-the-counter. My point is that most companies are not publicly traded and, therefore, inaccessible to most investors. Private Equity (PE) investors, on the other hand, invest in companies that are not traded on a stock exchange (i.e. private). There are tens of thousands of large, successful private companies that you most likely have never heard of. IRS statistics show that there are over 160,000 companies in the U.S. with over $10 million in revenues. The E.M. Kauffman Foundation also reports that each year 125-250 companies are founded in the U.S. that will eventually grow to over $100 million in revenues. So how do you invest in these companies? It is not easy for retail investors, but some of the best minds in finance make a very good living investing in private equity.

How do private equity investors operate?

Most PE firms take large (often controlling) stakes in established companies. The objective is to buy companies that have problems, inject the PE firm’s capital and expertise to make the company more profitable, and then sell the company for a profit. The PE firms typically work with their companies over a period of years to turn them around, and hence, most PE investments are long-term and illiquid. Many different types of PE firms and strategies exist, including venture capital, leveraged buyouts, mezzanine debt, distressed debt, etc. PE firms raise money to invest in a portfolio of companies. Overall, 70% or more of private equity investments are made by pensions, foundations, and endowments. The other 30% are made by very wealthy individuals and families, who can meet the seven-figure-minimum investment.

Naturally, mutual fund companies and ETFs have tried to get in on the action and bring private equity to the masses. The results have been mixed at best. PowerShares Global Listed Private Equity ETF (PSP), for example, has 24% more volatility than the overall stock market and has experienced mediocre overall returns since its inception in 2007. The average annualized return over the past five years has been 4.24%.

Stealing the show from public stock markets?

Despite the lackluster results of the past few years, we believe Private Equity will continue to become an asset class of greater importance. One reason can be found by looking at changes in the IPO market. Historically, companies went public when they needed capital for growth. These days, companies can get all the capital they need from PE investors without the red tape or costs of going public. Therefore, IPOs are more often a liquidity event for insiders than a way to create value for new shareholders.

Take Uber for example. Many retail investors are excited to see this company go public. However, the company is already valued at an eye-popping $70 billion. That’s more than Costco, American Express, or General Motors. Even if Uber continues to be a great success, the question is, “Has most of the wealth creation already been captured in the private market (pre-IPO)?”

We expect the ability of retail investors to access private equity through mutual funds and ETFs to improve. Neither of these instruments are quite ready in our opinion, but we will be watching closely and keep you apprised of our research.