Private equity as an asset class

Investment in private equity is relevant because it offers an excess return compared with investment in listed shares combined with a diversification which increases the robustness of the total portfolio.

Historically, private equity has generated handsome returns for investors. In the period 1980-2011, the top quarter of the best performing European buyout funds yielded an average return of 30.1% pa. Private equity funds of almost all vintage years from 1984 to 2008 have offered a significant excess return compared with equivalent investments in the S&P Index – approximately 3.0% annually!

In private equity, value is created through active ownership – a dedicated owner with access to additional capital for growth funding. Active ownership is even more important for value creation in periods of difficult market conditions.

Active ownership includes constant focus on identifying and introducing value-adding measures, including acceleration of long-term growth and implementation of lasting operational improvements. The typical tools are a strong management team, including a board of directors that solely serves the interests of the owners, efficient reporting systems and short decision-making processes.

At SPEAS we are convinced that the constant focus on value creation will continue to generate excess return on private equity investments.

Private equity focuses on long-term value creation, due to the very fact that the ownership period is limited. The value of a company at the time of divestment is fundamental for a good return on private equity, successful companies naturally achieving higher values.

In addition to active ownership, private equity also creates value for investors through efficient investment and divestment processes and optimisation of capital structures. On acquisition of a company, the private equity fund usually has access to all relevant information and prepares a detailed business plan in cooperation with management prior to acquisition. As the private equity fund is able to inject additional capital into the company, it is possible to optimise the capital structure in the ownership period, and often the divestment process is prepared already on acquisition of a company with a view to identifying the most obvious buyers.

Of course, the private equity market also has its pitfalls. The asset class is illiquid and entails a high risk and is only suited for long-term investors. Moreover, investment in private equity involves relatively high costs, as the private equity model with its selection of investments and active ownership is resource-intensive, and the selection of and investment in private equity funds require a lot of work. The selection of and access to successful private equity funds are decisive to the return, and investment in the most successful funds offers handsome returns compared with investment in average funds.

Private equity allocation
In addition to excess return, private equity also offers long-term investors diversification. However, the diversification gain is difficult to assess in practice, as the data basis for private equity is of course limited. Thus theoretical models typically indicate an optimum private equity allocation of between 0% and 30% of the assets.

In practice, many European institutional investors choose a private equity allocation of up to 10% of their total assets. However, in the US there are several examples of major institutional investors placing 10-20% of their total assets in private equity, some even more than 20%.

Against this backdrop, long-term investors should be able to allocate up to 20% of their assets for private equity, depending on their risk profiles: