Implementing Private Equity Options in Institutional Portfolios
In the weird world of alternative investments, private equity is perhaps the most recognizable and most easily understood of the major asset classes. Individual investors, regardless of market experience, are generally familiar with venture capital-backed companies like Google, Facebook, Uber, and Snapchat. Similarly, though they may not realize it, most investors have interacted with many companies transformed by the buyout industry, including Hertz, Hilton, and PetCo. Each of these companies accepted equity capital from a private equity fund, which primarily means the investment occurred outside of a stock exchange like the NYSE or NASDAQ.
Surprising to some is the fact that institutional investors—typically public, corporate, and union pension plans, as well as cultural and educational endowments and foundations—have contributed by far the majority of capital supporting such investments.These institutions make investments with private equity managers as a part of their asset allocation process, hoping to access some of the unique advantages private investments offer over public ones.
While the CFA curriculum provides a high-level overview of leveraged buyouts and venture capital, the place of these investments within investors’ portfolios receives less focus. Here, I’ll provide a brief overview of the most common private equity investments and their purpose in institutional portfolios.
Venture Capital: High Risk and High Reward Technology Investments
Thanks to the ever-increasing presence of technology in our daily lives, it’s difficult at this point to find a sector of the economy that isn’t facing disruption at the hands of venture-backed software companies. Venture capitalists provide capital to firms that are inventing, commercializing, or scaling new technology. This frequently results in long hold times and a wide range of investment outcomes. Facebook’s early investors, for example, earned 247 times their investment in one of the most successful venture capital investments ever. This is balanced by the many venture-backed firms that are not able to commercialize a product and quietly shut down without returning any capital to investors.
The size of the venture market is also constrained: there are a limited number of world-changing technology ideas in a given market cycle, so the best firms are extremely competitive. Finally, venture capitalists are minority investors, meaning the company’s founder retains control of his or her firm.
Venture capital offers institutional investors a chance for outsized results with an elevated level of risk. Because of this high-risk, high-return profile, most institutional investors use the strategy to supplement other forms of private equity.
Leveraged Buyouts: Mature Companies Large and Small
Leveraged buyouts represent the plurality of private capital fundraising; a significant majority of real estate, infrastructure, fund of funds, and secondary funds are excluded. Leveraged buyouts work as follows: private equity investors purchase a company through the use of debt and equity, attempt to grow revenues or earnings while paying down debt, and then sell the newly improved company to other investors who attach a higher value to the enhanced financial metrics.
Leveraged buyouts are implemented across a wide array of industries (industrials, consumer, energy, business services, etc.); sizes (for every Hertz, there are many smaller buyouts focused on niche manufacturers, local business services, or other modestly sized firms); and value creation techniques (operational improvements, cost cutting, funding new growth initiatives, etc.).
In line with their fundraising status, leveraged buyouts form the core of most institutional investor portfolios. They tend to have a narrower range of outcomes when compared to venture capital, with more funds returning 1.5 or 2 times investor capital over a 10- to 12-year period.
Growth Equity: Lower-Risk Technology Investments
Think of growth equity as a hybrid of venture capital and leveraged buyouts. Target companies tend to have successfully commercialized a product, with positive earnings and growth that exceeds GDP, but they lack the total addressable market of Uber and Snapchat. Many growth equity firms rely on technology, but generally as an improvement to existing services rather than a wholesale replacement.
Similar to venture capital, the number of growing technology firms is rather more limited than the number of potential leveraged buyout targets, so growth equity investing necessarily forms a smaller part of most portfolios. The returns associated with growth equity funds, as you would expect, tend to be less dispersed than venture capital but higher than leveraged buyouts.
Special Situations, Turnaround, and Distressed: Stressed and Broken Companies
While there is significant overlap between leveraged buyouts and their distressed peers, there is a differentiated subset of buyout managers who focus on purchasing companies that are in operational trouble. As the saying goes, bad management isn’t cyclical, so there are always troubled companies for turnaround managers to target for improvement.
Institutional private equity portfolios frequently include a small allocation to turnaround, special situations, and distressed managers, given the downside protection inherent in buying a company whose value is mostly contained in assets like equipment and real estate. Special situations funds offer returns similar to leveraged buyouts, with less potential cyclicality due to the larger number of target investment firms in economic downturns.
Mezzanine: Debt with a Dash of Equity
Though it can be a fixture of both private equity and private debt portfolios, mezzanine investments are primarily debt with some equity attributes. Mezzanine securities are the most junior debt investments in a private company, offering yields commensurate with the associated risk. Mezzanine debt also often includes warrants alongside the debt investment, allowing mezzanine investors some participation in the equity returns of the company.
Similar to turnaround and distressed managers, most institutions allocate a small portion of their overall portfolio to mezzanine investments. Mezzanine provides reasonable yield and a shorter return of capital alongside a lower overall risk and return profile.
The Institutional Private Equity Portfolio
Though there are numerous other strategies within private equity, venture capital, leveraged buyouts, growth equity, special situations/turnarounds/distressed, and mezzanine make up the foundation of most institutional portfolios. With the differing risk and return profiles of each of these strategies, investors will allocate based on their unique risk and return goals.
Private equity portfolios vary wildly based on the institution, but a model portfolio could be allocated 60% to buyouts, 15% to venture capital, 10% to growth equity, 10% to special situations, and 5% to mezzanine debt. The model portfolio would provide a strong base with a small yield and upside in the case the investor’s venture or growth investments do especially well.
Hopefully this has provided some context for use of private equity and alternatives in potential portfolios, but this is only a brief overview. Each of these strategies has substantial variations among funds and savvy investors can build portfolios that can be highly accretive to the institution’s total portfolio.
About the Author
Kirby Francis, CFA, is a senior manager research analyst for RVK, Inc., an investment consulting firm located in Portland, Oregon. Kirby is a member of RVK's alternatives research team and is involved in sourcing and conducting due diligence on private equity and private real assets investment opportunities. He also provides private markets research and education to RVK's clients and consulting teams. Kirby previously worked for a private equity-owned cleantech firm, also in Portland. He holds the Chartered Financial Analyst designation and is a member of the CFA Society of Portland.