What is private equity?

1. Basics

Private equity is a form of investment in which capital is raised from large insurance companies, pension funds, foundations and wealthy private investors in order to invest it in private, unlisted companies. The investment spectrum ranges from young start-ups and dynamic growth companies to established organisations with proven business models.

Specialised private equity management, often referred to as General Partners (GPs), takes care of the composition and ongoing management of the portfolio of around 10 to 30 individual companies, depending on the strategy.

Private equity typically aims to acquire a majority stake in companies and to realise a significant increase in value during the investment period. The holding period is usually around 3-7 years. The company is then sold again as planned. The limited investment period requires private equity management to give intensive thought to the selection of target companies, their potential for value appreciation and an attractive purchase or sale price.

Private equity is a private market investment and, unlike traditional asset classes such as stocks, bonds and commodities, is not traded on public markets, i.e. stock exchanges. It is not the investor who decides when to exit an investment, but the private equity management. This tends to make this asset class illiquid and requires a long-term investment horizon.

2. Relevance and returns of private equity over time

Over the past 25 years, private equity has established itself as an asset class on the global financial market and makes a significant contribution to the economic growth of various industries and companies. By combining strategic advice, active value creation and the provision of financial resources, private equity can promote operational efficiency as well as long-term development and innovation. The volume invested in private equity has almost quadrupled globally to USD 15 trillion between 2013 and 2023 and is expected to increase further to USD 29 trillion by 2030.¹

Numerous institutions with a long-term investment horizon, such as large pension funds or the foundations of the US universities Yale and Harvard, now use private equity as part of their portfolio.

As private equity management often acquires majority shareholdings and can intervene directly in the portfolio companies, it is possible to implement decisions quickly and act efficiently. As privately managed companies are not subject to quarterly reporting obligations, long-term value enhancement potentials that promise little added value in the short term are often addressed.

The average return on private equity investments over the past 20 years in US dollars was 14.9% per year, which is higher than the return on global equity markets of 8.6% per year, measured by the MSCI World index of industrialised countries.²

3. Advantages and disadvantages of private equity

Private equity can offer a number of advantages, but also some disadvantages compared to traditional equity market investments.

Advantages

Private equity offers exclusive access to private companies. Only 12% of all companies worldwide are listed on the stock exchange and can therefore be invested in via the stock market.³ The vast majority are in private hands. With private equity, investors can diversify their portfolio even more broadly and gain access to promising companies outside the stock market, which was previously the preserve of institutional investors and family offices.

Professional management promotes value enhancement. Through active management, the General Partners contribute to unlocking long-term growth potential and optimising operational processes. They act as strategic advisors, but also oversee the management of the companies. This can lead to an increase in sales and profits and ultimately contribute to an increase in company value.

Private equity can improve the risk-return profile of an existing portfolio. Analyses by the BlackRock Investment Institute show that an addition of up to 20% private equity can improve the risk-return profile of a portfolio. Over the period under review, the expected return on the portfolio (60% equities, 40% bonds) rose from 5.5% to 7.2%, while the risk increased only slightly from 11.3% to 12.7%.⁴

Promising companies are increasingly staying in private hands for longer. Emerging growth companies are now staying private longer than in the past. The average time to IPO rose from 8.6 years (1992-2001) to 11.1 years (2002-2022)⁵. A significant proportion of value creation is therefore shifting from the public stock market to private markets. Private equity can be used to participate in this source of income.

Disadvantages

The invested capital is locked up for a longer period of time. With private equity, the General Partners (and not the investors) determine the appropriate time to buy and sell the company investment. Due to the importance of private equity, a large market for private entrepreneurial investments has developed over the last two decades, but transactions can still come to a virtual standstill at times when trading interest is low. The value of the investment cannot be viewed on a daily basis. As private equity is not traded on stock exchanges, the value of the investment cannot be measured on a daily basis. Instead, the General Partners publish the intrinsic value of an investment regularly (e.g. monthly) in the form of the net asset value (NAV).

The costs are higher than for traditional ETFs. Due to active management, the fees for private equity are higher than for traditional funds and ETFs. The ongoing costs of a private equity fund are generally made up of management fees and possible performance fees if a certain minimum return is achieved. They are taken from the fund assets and are not invoiced separately. Depending on the provider, order fees, front-end loads and other fees may also be incurred.

4. Structure and process of the investments

Anyone wishing to invest in private equity must participate in a private equity fund, which pools the capital of various investors, also known as Limited Partners or LPs. The management team takes care of the ongoing management of the investments and seeks to generate returns for the fund.

The collected capital can be invested in individual portfolio companies. As part of deal sourcing, the private equity fund actively searches for suitable and attractive investment opportunities. As soon as a company has been identified as promising, a comprehensive due diligence and a detailed company valuation follow in order to determine the current value and possible future growth levers. As soon as all parties involved have agreed on a purchase price, its financing and the legal documents, the purchase process can be finalised.

During the holding period, the aim is to increase the value of the company. The focus is on realising efficiencies and accelerating the company's growth. This includes expansion into new markets, product innovations and strategic partnerships along the value chain.

After around 3 to 7 years, the portfolio companies are sold (exit) at a suitable time in order to realise a return and repay the funds invested to the Limited Partners. The best-known exit option is going public, where shares in the company are offered to the public for the first time (initial public offering). Another option is a sale to a strategic investor who wishes to expand its product portfolio or strengthen its market position through the takeover. There is also the secondary buyout, in which the company is sold to another private equity fund. This strategy can be advantageous if the potential for value enhancement has not yet been fully exploited, but other resources or further expertise are required. The choice of exit strategy depends on various factors, including market conditions and the characteristics of the company. As a rule, the General Partners already have possible exit options in mind at the time of purchase and try to optimise the company accordingly over the course of the holding period.

5. Strategies of private equity

Within private equity, there are various strategies that have a significant influence on the structure of the portfolio and the expected risk/return profile of the investment.

Buyouts

(Leveraged) buyouts are the most important private equity strategy with the highest invested volume. In a buyout, majority stakes in companies are usually acquired with the help of debt capital. Over time, the borrowed capital is then repaid through the profits generated, so that the investors' equity gradually increases.

The prerequisite is that the company has a stable business model, ongoing positive cash flows and low operating risks. The advantage of debt capital is that companies can procure capital relatively cheaply, debt capital is favoured by companies for tax purposes and ongoing repayments force companies to be disciplined in their spending.

In some cases, buyouts are implemented together with a ‘buy and build’ strategy. In this case, the company expands its business area through neighbouring acquisitions in order to access further growth opportunities or higher margins.

Venture capital

Venture capital is also part of private equity in a broader sense, but has a fundamentally different investment approach. The strategy invests in start-ups or young companies that promise strong growth. In contrast to buyouts, financing is provided almost exclusively with equity capital. As the business models are generally only established on the market to a limited extent or not at all, an individual investment is associated with a very high risk. An individual company can rise by a multiple of its initial value, but only fall by a maximum of the amount invested. It is therefore important to diversify the risk across many different start-ups in order to include future winners in the portfolio.

Other strategies

Other private equity strategies include distressed investments, in which funds invest specifically in companies at risk of insolvency in order to put them back on a stable development path. The growth equity strategy focuses on high-growth companies with an established business model. Both strategies pursue a high-risk investment approach and are heavily dependent on external influences.

6. Conclusion

Private equity offers a wide range of opportunities to invest in private companies outside the stock market and to further diversify an existing portfolio. Over the last two decades, private equity has become significantly more important, especially for pension funds, foundations and family offices. The most important characteristic of private equity is the required long-term investment period, which is accompanied by lower liquidity compared to exchange-traded investments.

Of the various investment strategies in private equity, investments in established companies (buyouts) are the most relevant (in terms of volume). Private equity management actively contributes to realising the potential for value appreciation. The costs of private equity are therefore generally higher than those of traditional exchange-traded ETFs or funds. In return, investors can benefit from the high potential returns of this asset class. However, past returns are not a reliable indicator of future performance.

¹ Source: Preqin. Private equity inclusive Venture Capital. Forecasts are not guaranteed to be accurate. Status: Q1 2023.

² Source: Burgiss. Status 30. September 2024. Private equity investments are represented by the Burgiss Private Equity Index (buyouts) after fees. Only private equity funds (investing in established markets) (number of funds 1,976). Bloomberg. Status: 30 September 2024. The MSCI World Index represents large and medium-sized companies from 23 industrialised countries before fees. Past returns are not a reliable indicator of future performance.

³ Source: Capital IQ. Number of global companies with an annual turnover of more than USD 100 million. Status: 31 December 2023.

⁴ Risk and capital market assumptions data as of 30 June 2023; currency: EUR; period: 10 years. The return assumptions are nominal total returns. Expected returns are net of assumed fees. Fees and alpha are estimates for illustrative purposes and do not represent actual fund performance.

⁵ Source: Capital IQ, as of 31 December 2023. Number of global companies with annual sales of more than USD 100 million.