In recent years, interest in “alternative investments” has exploded. In a world of high stock market volatility and falling bond prices, many investors — particularly institutional and high-net-worth investors — have sought to diversify their portfolios with new assets. Alternative assets, which have a low correlation to traditional asset classes such as stocks and bonds, have offered a solution. Not only have these assets enabled investors to create more balanced portfolios, but they have also enabled them to capture new sources of return.
Among the groups of companies that are benefitting from the growing interest in alternatives are private equity (PE) firms. A subset of the alternative investment market, private equity refers to ownership interest in companies that are not publicly listed or traded. Firms that operate in this space raise money from investors and then deploy this capital into businesses that are believed to have significant growth potential. They then take a cut of the profits if their investments are successful. It’s a lucrative business model that can generate strong returns for shareholders over the long term.
Here, we take a closer look at how the private equity world works, and discuss why it could be a good time to consider private equity stocks for your portfolio.
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How does private equity work?
The private equity (PE) world is essentially composed of funds and investors that invest in private companies with the aim of generating better returns than they can get from the public markets.
At the heart of the industry lie private equity firms such as Blackstone, KKR, The Carlyle Group, and Apollo Global Management. These investment firms raise money from a range of investors, including institutional investors (pension funds, sovereign wealth funds, insurance companies, endowments, etc.) and high-net-worth individuals, and pool this capital together to create PE funds. These funds then make investments in companies that have significant potential.
Most of the time, private equity firms use the capital raised to invest in start-ups and private companies in industries such as technology, healthcare, and biotechnology. The capital may be used to fund new technology, make acquisitions, expand working capital, or bolster balance sheets.
However, sometimes PE firms use the capital they have raised to acquire control of public companies so that they can take them private in a process known as a “buyout.”. The goal here is to improve the businesses — away from the scrutiny of public market investors — and resell them for a higher price later on. This approach may be used if a business has a valuation that is lower than its cash reserves on its balance sheet.
Often, private equity firms try to add value to the companies they invest in. For example, they might take some seats on the board, bring in a new management team, aggressively cut costs, or spin off areas of the business that are underperforming. These moves can help to maximise the value of the businesses.
The rewards can be substantial. Typically, PE firms make money through both management fees and performance fees. So, for example, they may charge a 2% management fee annually on managed assets and then 20% of the profits gained from the sale of the businesses. The higher the return on investment the funds earn, the greater the firms’ performance fees.
Private equity deals in the real world
It is worth pointing out that private equity funding has helped many well-known companies get to where they are today. Some examples of companies that have benefitted from PE in recent years include:
- Airbnb: After Airbnb had to postpone its plans for a 2020 IPO due to the coronavirus pandemic, the company raised more than $1 billion in funding from PE firms Silver Lake and Sixth Street Partners. Airbnb said at the time that the funds would be used to invest for the long term. When Airbnb finally came to the market in 2021, its share price exploded higher, so these firms most likely earned a strong return on investment.
- Hilton Worldwide Holdings: In 2007, the Blackstone group took Hilton Worldwide (then Hilton Hotels Corporation) private in a leveraged buyout (LBO) deal worth $26 billion. In the years ahead, Blackstone restructured Hilton’s management, debt structure, and operational processes, and turned it into a much more profitable organisation. They then relisted the company via an IPO. Overall, Blackstone made about $14 billion profit from the LBO.
- Lululemon: In 2014, Advent International acquired half of Lululemon founder Chip Wilson’s stake in the athleisure company for $845 million. Advent Managing Partner David Mussafer and Managing Director Steven Collins then joined the board in an effort to improve the company’s performance. They achieved their goals and it paid off in a big way. Since this deal, Lululemon’s share price has risen from around $40 to $280.
The benefits of adding private equity stocks to a portfolio
For investors, there are a number of potential benefits to incorporating private equity stocks into a portfolio. Some of the main benefits include:
- Exposure to the private equity market. Direct private equity investing is not easily accessible for the average investor. That is because most PE firms typically only serve investors that are willing to commit hundreds of thousands, or even millions of dollars. Yet, by investing in the stocks of these firms, investors can gain exposure to the market. By owning shares of these investment companies, investors can take advantage of their expertise and high level of profitability without having to stump up as much capital as they would if they were investing in the actual private equity funds.
- The potential for strong long-term returns. The private equity market is growing at a rapid rate right now on the back of high demand for alternative investments and this is reflected in the share prices of many firms within the industry. Blackstone and KKR, for example, have seen their share price rise by around 170% and 150% respectively over the last five years. Many PE firms pay regular dividends too.
For Illustration purposes only. Past performance is not an indication of future results.
- The ability to back high-growth companies and entrepreneurs. The PE market enables investors to gain exposure to smaller, up-and-coming businesses that are a little more under the radar, as well as to visionary leaders. An example here is Fortnite creator Epic Games which has received considerable PE funding over the years. Back in 2018, its valuation was under $5 billion. Today, however, it has a valuation of over $30 billion.
- Exposure to major technology trends. In recent years, many PE firms have invested in technologies whose use was accelerated by the pandemic. Examples of such technologies include cloud computing, enterprise software, and cybersecurity. Earlier this year, for instance, KKR and Global Investment Partners acquired data centre operator CyrusOne for $15 billion.
- Diversification. When investors seek out stocks in the financial sector, they often go for bank stocks. Investing in PE firms can offer an alternative way to play the financial sector.
Why now could be a good time to consider private equity stocks
Looking at what’s going on in the capital markets today, it could be a good time to consider private equity stocks. Right now, the world’s financial markets are experiencing a major valuation reset. As a result, the valuations of both public and private companies — particularly in the technology space — have fallen significantly. This valuation reset is likely to create some attractive opportunities for PE firms, as they will be able to invest in innovative businesses at much lower valuations. Buying low should ultimately increase their returns over the long run, which in turn, should boost shareholder returns.
To help investors get exposure to private equity stocks, eToro has created the Private-Equity Smart Portfolio. This is a fully allocated investment portfolio focused specifically on publicly listed PE firms. Designed for long-term investors, this Smart Portfolio provides one-click access to the private equity world, and offers exposure to some of the leading names in the industry including the likes of Blackstone, Apollo Global Management, KKR, and Carlyle.
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Copy Trading does not amount to investment advice. The value of your investments may go up or down. Your capital is at risk.
Copy Trading does not amount to investment advice. The value of your investments may go up or down. Your capital is at risk.
eToro AUS Capital Limited ACN 612 791 803 AFSL 491139. Smart Portfolios are not exchange-traded funds or hedge funds and are not tailored to your specific objectives, financial situations and needs. Your capital is at risk. See PDS and TMD.