Yago del Villar is responsible for the private client product offering at LGT. He explains what private investors should look out for when it comes to private equity and why this asset class is not suitable for every investor.
Mr. del Villar, private equity is becoming an increasingly important asset class for many institutional investors. Should private investors also be investing more in private equity?
That’s not something that can be answered with a general statement. Although there is much to be said for this asset class, private equity is not suitable for every investor. Similar to equities, for example, investors should have a higher capacity and willingness to take risks and be able to tie up the invested capital for a longer period of time. But if a private investor has the right risk profile, then private equity provides a very attractive opportunity to further diversify their portfolio because the correlation to traditional investments is low. At the same time, they have the possibility of generating higher returns than with listed equities. Compared to traditional forms of investment, however, private equity is quite complex and therefore needs to be explained: that’s why we attach great importance to providing our clients with in-depth advice on the characteristics of this type of investment and on the opportunities and risks associated with it.
What makes private equity such a special asset class for investors?
Private equity is similar in some respects to an investment in listed equities: you participate directly in the company’s equity capital and success. However, there are also some major differences; the biggest ones are probably the time horizon and liquidity: if I buy a Nestlé share, I can sell it at any time at the prevailing market price. With a private equity investment, on the other hand, I need to have an investment horizon of at least ten years. As a general rule, I don’t have the possibility to exit early, and if I do, then usually only with a substantial loss. This significantly limited liquidity is the price that is paid for the higher return opportunities compared to listed equities. Another specific characteristic of private equity is the timing of capital flows: as a private equity investor, I commit a certain amount of capital; however, this capital is not immediately drawn down by the fund, but only when it is needed for an attractive investment opportunity. It is also not known when the fund will liquidate the various participations and what profits it will make as a result. This means that investors do not know when they can expect to receive distributions or how much they will receive. Private equity therefore needs a lot of patience and the ability to deal with irregularly staggered capital flows. By far not every investor meets these requirements.
Funds of funds enable a level of diversification that would be impossible if the same amount were invested in direct investments.
What about transparency?
This is another area where the difference to listed equities is big. In the case of listed equities, the information that is important for investors is publicly accessible to everyone. However, private equity funds usually invest in unlisted companies that are subject to very limited disclosure requirements. This means that only private equity funds, not individual investors, have any real insight into how the business is developing. Nor is there any price transparency: in the case of Nestlé, I always know what a share is worth on the market and what my overall performance was over a specific period of time. With private equity, I only find out what the overall performance was after the fund has been liquidated, i.e. after an investment period of several years. Although the net asset value is determined on a quarterly basis, this is based only on estimates made by the fund manager.
Let’s say I want to invest in private equity as a private investor. What are my options?
Direct investments in companies or in private equity funds are only accessible to very few private investors. Funds of funds are therefore probably the most suitable solution for the majority of private investors. They provide otherwise difficult access to this asset class and enable a level of diversification that would be impossible if the same amount were invested in direct investments.
And what about listed private equity investments?
Listed equities of private equity firms or listed funds are another way to invest in private equity. Such instruments provide direct and liquid access to this asset class. However, this also means that one of the major advantages of private equity is lost, namely returns that are relatively uncorrelated to stock market trends. In other words, in the long term, the returns on listed private equity investments will at best be equivalent to those of traditional private equity investments. In the short term, however, they are exposed to volatility on the stock markets, and their value can fluctuate very significantly. It should also be noted that listed private equity firms often trade at a large discount to the net asset value of their investments over long periods of time.
Are there any specific times when investing in private equity is particularly attractive?
Timing is a secondary consideration when it comes to private equity: due to the long holding period, which often extends over more than one economic cycle, determining the most appropriate time for an investment makes little sense. It’s more important to invest with a certain regularity, or in other words, to diversify across different phases of the business cycle. It’s also important to diversify across different investment managers and styles, different development and financing stages of companies, as well as across sectors and geographic regions.
What is the potential impact of Covid-19 to the asset class?
While the equity markets have rebounded from the March lows, there is still a significant dislocation with ripple effects on the economy difficult to quantify at this juncture. The private equity industry is not immune to such economic shocks and, while no two crises are the same, we can take some clues on the potential impact from past crisis like the global financial crisis (GFC). What looking at past crisis behavior tells us is that periods of rapid market dislocation and economic contraction will affect asset valuations, reduce distributions and increase capital calls as fund managers draw from existing commitments to support their portfolio companies. We also learned that those vintages can be very attractive for new commitments to the asset class.
In summary, private equity tends to reward investors who are consistent and thoughtfully opportunistic. While there will undoubtedly be an impact on existing private equity portfolios, market dislocations create opportunities for investors with a consistent approach. Investors should consider long-term investment plans when building private equity portfolios, rather than reacting to short term market sentiment
What else should investors who want to invest in LGT private equity solutions keep in mind?
Private investors should have a long investment horizon of between ten and fifteen years and be able to invest at least USD, EUR or CHF 250 000. The investor’s country of residence is also important, which means that for each client and depending on the program, we have to check whether an investment is even possible for legal and regulatory reasons.
And how big should the allocation to private equity be in a diversified portfolio?
The ideal allocation depends on the investor's risk appetite and overall target return. Allocations range widely: family offices, for example, allocate an average of 26 percent of their portfolios to private equity, while this share is around six percent for pension funds.
Pictures: Raphael Zubler
Yago del Villar received his master’s degree from Universidad Autónoma de Madrid and has around 20 years of experience in investment and private banking. He is responsible for Offer Management Private Banking at LGT.