This publication is Part 1 of a Private Equity series prepared by BMO Family Office with the aim to raise awareness and understanding on a variety of private equity investments, and how they can be utilized to potentially enhance client portfolios. This article provides an overview of the private equity landscape, the anticipated benefits and returns, and potential considerations of private equity investments.
Broadly, private equity refers to investing in the shares of companies that are not yet publicly-traded. Publicly-traded companies are businesses that can easily be bought or sold on exchanges such as the Toronto Stock Exchange in Canada or the New York Stock Exchange in the U.S. The three main categories of private equity are secondaries, buyouts, and venture capital.
Private equity investing is regularly utilized amongst large institutions and family offices globally. For additional context on the growing popularity of this asset class, a 2022 UBS Family Office Report indicated that the average family office has a 21% weight in private equity.
Understanding how long-term investors, such as world-renowned pension plans, are investing in private equity helps demonstrate that this is not a short-term trend. Focusing specifically on two of the largest portfolios in North America: the Canada Pension Plan (CPP) has a 2022 private equity allocation of 32%; and CALPERs, the largest public pension in the U.S., raised its target allocation to 13%, up 5% from their most recent target.
Benefits and Return Profile
As previously mentioned, it is evident that Ultra-High Net-worth (UHNW) individuals and institutions alike, recognize the value in deploying significant capital into private equity. Some potential reasons as to what is drawing this interest include:
Companies are remaining private for longer – resulting in firms being more mature when they decide to go public. Private equity allows investors to access these firms while their growth potential is still relatively high.
Price volatility – generally private equity has the potential to provide a higher rate of return for a given amount of volatility. This is becoming increasingly valuable given greater unpredictability in public markets in recent years. This effect can potentially enhance returns without taking on meaningful increases of price volatility.
1St. Dev short for standard deviation.
2Private Equity represented by Private Equity data collected by Prequin.
Diversification – private equity can broaden investment opportunities as investing in public markets only can limit the investable universe. Allocating to private companies improves portfolio diversification which may lower the risk of the entire portfolio, while providing investors access to companies that may never be publicly traded.
Return potential – private equity provides the potential for higher returns given typical investment horizons of target assets are longer and management can usually exercise more control. This dynamic creates the opportunity for enhanced risk-adjusted returns compared to traditional public markets. The chart below from Hamilton Lane demonstrates that broad private equity has outperformed the public market by over 6.96% per year for the past 20 years. While this is by no means a guarantee and returns vary by asset class, it does help illustrate higher return potential in private equity.
Source: Bloomberg and Hamilton Lane Data via Cobalt as of 3/31/2022 (October 2022). Public Equities is represented by the MSCI World Net Total Return Index and Private Equity represented by Private Equity return data though Cobalt.
While there are some compelling reasons to explore having a private equity allocation in your portfolio, it is believed that most qualified Canadian investors hold well below the private equity allocations of top institutions and family offices. Some possible reasons for this discrepancy are as follows;
Higher fees are often a hurdle for investors who seek to reduce fees at all costs. While investors should not overpay for investments, bargain hunting in specialized investments often results in allocating to lower quality managers which can be a greater risk to investors. Your BMO financial professional has access to top-ranked managers with competitive fees. In addition, these managers target higher returns ~ on a net-of-fees basis ~ and have historically outperformed public market results.
Unique investment characteristics often act as stumbling blocks to investors. Most private equity investments are open for investment for only a short period of time (some as little as one month). After this investment window closes, there is typically have a three-to six-year investment period, resulting in a total 10-year investment term. This means if an investment is made today, it will take three to six years to get the funds mostly invested and around 10 years before the investment is returned and gains distributed. Illiquidity provides management with the ability to deploy capital opportunistically, without being obliged to meet fund liquidity needs and allowing for an expanded opportunity set and enhanced returns. In addition, private equity is a building block for portfolios, where more traditional asset allocations can be used for liquidity needs. Overall, limited liquidity often intimidates individuals from investing; however, investors who can tolerate these illiquidity characteristics can potentially benefit from the differentiated return profile and diversification benefits private equity can provide.
The J-Curve – a phenomenon that occurs in most traditional private equity investments. Investments typically see negative performance in the first few years when the fee burden is the highest and capital is being invested. As time passes, portfolio companies generally begin to appreciate in value and distributions result in returns becoming positive. While this initial dip is a normal characteristic of the private equity space, many investors have not been properly educated regarding this aspect of the asset class and often become anxious when they see negative performance in the first few years. It is important to note that it is an industry standard or not to report performance in the first three years of a private equity fund’s life, as the performance – whether positive or negative – is not representative of the fund’s actual return profile. In addition, private equity tends to have less transparency and different reporting standards amongst its diverse entities.
Example used is a 10-year investment term.
Limited access – perhaps the largest factor that has contributed to individuals, more broadly, being unable to invest in this asset class. Historically, most private equity funds have only been marketed to institutions, foundations and specific UHNW individuals. This is largely due to the high minimum investment associated with private equity, resulting in it being nearly impossible for most investors to access. While this asset class remains only suitable for High Net-worth (HNW) or UHNW investors, advances in technology and regulatory changes are improving the accessibility of private equity to qualified and suitable investors.
Evergreen Private Equity
Investors who are not comfortable with some of the challenges discussed in this article, may be interested in evergreen private equity strategies, as they typically do not present as many challenges as previously outlined. Evergreen private equity strategies are designed to provide private markets access with a single allocation, monthly or quarterly limited liquidity, low investment minimums, and immediate exposure. While evergreen solutions provide an easier way to access the asset class, the increased flexibility does come with lower return expectations compared to traditional private equity strategies.
While investors should be aware of the challenges when investing in private equity, working with an experienced investment professional will help investors manage any concerns and help build an understanding of what to expect throughout the investment term. Investing in private equity will allow qualified individuals the opportunity to enhance returns, similar to how large institutions have been benefitting from private equity for many years.
If you are interested in discussing private equity solutions as a potential opportunity for your portfolio, please do not hesitate to reach out to your BMO Private Wealth professional.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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