Should You Invest in Private Equity?
28:15 Share

Walking the money for the rest of us. This is a personal financial on money. How would works, how to invest IT and how to live without worrying about IT.

I'm your host, David. Dying today is epo de for ninety. It's titled should you invest in private equity. Recently, I received an email from a member of our premium community money for the rest of plus. He was asking about private equity, and he pointed out that in much of the world, the stock market is expensive and investment money is looking for opportunities. Yet there is a lot of capital already raised to invest in private equity, and he was curious whether that would impact return.

How has private equity performed? And we're going to discuss that in this sub sode, including what is private equity and can we as individuals participate in this asset category that has been very successful for rational investors. Private equity consist of really three areas, BIOS, growth capital and venture capital.

Buy out is when a fine or investors acquire a publicly traded or even a private company, alright? And they often use debt, the borrow money to help finance that purchase. That's why BIOS are sometimes called leveraged BIOS.

The management team is actively involved in this company purchase to improve Operations to grow the business. But these are typically established businesses that have been around for a number of years, and most of the time they are publicly traded. So they have publicly traded stock.

A fun might raise capital to purchase that publicly traded company and take a private venture. Capital is different. This is equity investment focused on on early stage company and startups that have high growth potential.

And then as these startups perform, they build out their businesses. Often times, there can be additional capital known as growth capital that are in these later stage companies. Venture capital. Growth capital is investments in private companies.

And with all of these strategies, the buyout ts, the growth capital, the venture capital, the ideas to have some type of exit so that the investors can get their money out and lock in their profits. And those exits come through an initial public offering. Taking this private company in issuing publicly traded stock or IT could be done through a biot.

Some other fun can come along and purchase the company. Traditionally, private equity investment has been done through a private fund structure with a general partner, that is, with the manager company. They are the ones that put the fun together.

They go out and raise capital from limited partners. So a limited partner could be a university in downtown in a private foundation that could be a family office. This are a very high network individual.

These partnerships typically last seven to ten years, but they could go longer than that if there are remaining investments where there's been no exit. I am in a private equity or private capital fund of funds from my former firm, and it's gone on for twelve years and they've just extended for another year. And so often times these funds can last more than a decade.

The general partner typically will co invest in the private equity fund. IT could be two percent of the capital, but they're go investing along with the limited partners. The fees can be Priced is typically a two percent management fee every year, and then the general partner will get twenty percent of the profits after some type of preferred return or hurdle rate is met.

So IT could be a preferred return of eight percent net fees to the limited partners before the general partner gets twenty percent of the profits. The way these funds work then is the general partner decides to raise a new fund. They raise capital, they get commit from limited partners.

And then as the general partner find opportunities, they'll call capital that the limited partners will then send to the fund. Typically, this capital calls are over three to five years of the life of the fund capital used. And then ideally, there are exits.

And as exit OCR capital is returned to the limited partners through distributions, the way the distribution typically worked in is, is first, any distribution from some type of exit or set r needs to cover management fees, debt service and cost, and then you'll get capital return to the limited partners part of the capital that they contributed to the fund. Then the limit partner will leave profits up until they reached the hero rate or preferred return. At that point, it'll be a catch up, allowing the general partner to get there twenty percent that do.

And then after the limited partner has received their preferred return, the general partner has there twenty percent. Then any additional gains distributions are distributed parade between the gender partner and the limited partner. I've been involved in private equity for several decades now. Back in the early two thousands, I was our chief portfolio strategist at my former firm, F A G. Advisers who had the research group.

And I was also involved in setting up a private capital research organization and and we were hiring people to do research, these limited partnerships, these funds in in the private capital space, including private equity, venture capital, well as real estate, energy and other real assets. I've also invested in private equity for over a decade now, primarily through my former firms, funds that we put together back in twenty ten, we started working on putting together fun of fun. So a fun of funds is a fun that in vest in underlying limited partnerships.

And so I was involved in putting those together SAT on the investment committee. Then I have subsequently invested in all six of the funds that they have raise. Ed IT makes up about sixteen percent of my investable assets.

I'll share a little later in this episode my experience and investing in private equity, how the returns have been before we continue. Let me POS and share some words. One of this week sponsors linked in when you're hiring for your small business, you want to find quality professionals that are right for the role.

That's why you have to check out lincoln jobs. Linton jobs has the tools to help you find the right professionals for your team faster and for free. I know in our business, we've seen how key IT is to have the right person for the role and linked in can help with that.

Linton isn't just a job board. Lincoln helped you hire professionals. You can find anywhere else, even those who aren't actively searching for a new job, but you might be open to the perfect role in a given month.

Over seventy percent of lincoln users don't visit other leading job sites. So if you're not looking on linked in, you're looking in the wrong place. And like ten, eighty six percent of small businesses get a qualified candidate within twenty four hours.

So a higher professionals, like a professional on linked in post your job for free at linton. Dot comes last, David. That's linkin.

Dot comes last, David. To post your job for free, terms and conditions apply. A limited partner will receive a statement, typically quarterly, of their investment for a particular fun biid adventure fund, a buyout fund.

And it'll show the net acid value that net acid value is there's some direction to how is determined, but I can at least be at cost what they find invested in a particular company if there is some type of valuation event. So there might have been a similar company that raised capital. There might have been at and exit or or something that they can assess the fair value they're trying to determine.

What is this company worth in a conservative manner, the underlying portfolio companies and then those build up to the value of the overall fun divided by the number of shares to get the net acid value per share with chAllenging with private equity is comparing IT to the stock market. Clearly there are similar risk, but because the value of bio phones of venture capital is done on an a praise al basis, typically quarterly, there's a lag. And so these funds are not trading on a daily basis and underline holdings.

And so IT IT appears that they're not as violation le because they're private. But there is risk there and will share some of that risk, I say, invested in the stock index fun. They published the returns daily and you can see what here's my year to day return here is the one year return, the three year return and and the type of returns of calculating is what is known as they time way to return in that IT doesn't really take into account the cash flows.

Wherewith a private equity investment because the partner determines when capital is called and when capital distributed, they do. It's known as a dollar waiter return, also known as a internal rador return. It's a basically looking at the cash flows over time in the terminal value of a current value and doing A A discount return calculation to figure out the overall return.

Another words given when capital was called, when I was distributed, what the n value is, what is the return that that would have achieved? Another was IT packs into a discount rate that would make all those cash flows sentiment neutral between getting that cash load today or in the future. It's a dolero return that the calculation is a little confusing, but these internal atto return calculation are not necessarily comparable to a time way to return calculation.

So when you look at a ten percent in generator return for a fund, a private equity fun is not like saying the stock market returned ten percent. There is one way that I can be done. You typically with a private equity fund, they calculate the internal return, which for many people isn't necessarily intuitive, but they also look at the total value to paid in capital so of what was paid in, how much cash lers were brought out.

And so if the amount paid in equal amount that was paid out, then that total value paid in capital be one. Ideally IT would be a closer to two or three if they funded incredibly well. So the two primary ways to look at private equity from a return time point would be the internal or turn as well as total value to paid in capital.

But there is also a calculation. And I found this in A A paper that dimensions devisers published. The coauthors were hedrick and meet at, and they looked at the universe, the msci private capital universe, which was formally known as the burgess manager universe.

IT has fun data from over a thousand limited partners that contribute their information on their underlying funds so that there's a database to kind of compare performance. Hendrix and meta looked at this data and they were trying to find a comparison of private equity data relative to the stock market, and they use was known as the captain shore public market equivalent. What IT is is IT IT calculated, assume that theory, a typical private equity limited partner ship.

They're calling capital and the distributed capital and there's a current value. IT assumes that that when that capitals called, it's take out of the stock market and then it's invested with the fun. And then when is dirigo ted? The money is put back in the the stock market and invested at whatever the return for the stock market is.

And so IT does this kind of this cash flow. calculation. And so then if this statistic, the what's known as the K S P M E is greater than one, then the private equity fund is Better than a comparable in the stock market, matching IT casual by cash, low in looking then.

And they went back several decades to to see the performance of private equity over time. And they found that this K S P M E measurement for bio funds on an equal rated basis across all the vintage. So a vintage year for private equity would be the year that the fund n was raised.

So a fund d raised in twenty four would have a vintage year twenty twenty four. And then I would be compared to other funds race and twenty twenty four in the biya space or the venture capital space. What they did then, these these academics, that dimensions, is they looked across all the vintage and found that the K S P M E was one point two when the benchmark used was the S M P.

Five hundred. If they use a smoke value benchmark, IT was closer to one point of six. But IT showed, and they concluded in the paper, and they use other benchMarks, that by a large bio funds and venture capital, looking at ten, fifteen, ten to seventeen year time, horizons outperform the compare stock market in aggregate, either on a equated basis or a capital waited basis.

There was persistent our performance on average. The problem is it's positively skill. There are biogas ds and venture capital funds that do incredibly well and some that don't.

And so if you look at the range of returns in a given vintage year, that range the top coral firm or the top fifty percent tile firm or find IT is going to be much higher than the bottom courtot or the worst fifth percent ta. The distribution of returns is much wider in the private equity space than IT is in the public markets. Before we continue, let me pause and share some words from this week.

Sponsors quick math, the lesser business spends on Operations, on multiple systems, on delivering your product or service, the more margin you have and the more money you keep. But with higher expenses of materials, employees, distribution and boring, everything costs more. So to reduce cost and headaches, smart businesses are graduating to net sweet by oracle.

Next sweet is a number one cloud financial system, bring ging accounting nature management in mentorian H R. In the one platform and one source of truth with next week, you reduce IT cost because next week lives in the cloud with no hardware required access from anywhere. You cut the cost of maintaining multiple systems because you've got one unified business management suite.

Improve efficiency by bringing all your major business processes into one platform, slashing mano task and nairs over thirty seven thousand companies. I've already made the move, so do the math, see how your profit with net sweet, with everything seeming to get so expensive these days, it's wise to find proven ways to cut costs and boost performance at the same time, next week can help with that. And by popular demand, next week has extended its one of a kind flexible financing programme for a few more weeks.

It's a net sweet dot comes flash, David. That net sweet dot comes slash, David. That sweet dot comes last, David. In looking at what drives the return, why do some funds do much Better than others?

In the private equity space, skill was prevalent, and the the most skilled managers do much Better than less skilled managers. Now part of the reason for the skill would be networks. The top of venture capitals, no other top to adventure capitalist, their limited partners know each other.

And in the private equity space, this is not a contest to see who can raise the most amount of money by a large for those funds that are very performance to focus because the more money you have, the more difficult if is to repeat excEllent performance because there's only so so many deals available and opportunities. And i'll linked to one paper titled unlacing. The power relationships and IT was by neto and Richard, and they found that the top cortile limited partners had access to the best venture capital general partnerships, and IT built those relationships over time, got access to them because they had a long standing partnership.

Meanwhile, you have smaller institutions that maybe haven't invested in this space, haven't been able to access those same partnerships. And so then we get a wide range to return. And then if we look at to just the sheer amount of capital that has been raised, IT has increased significantly.

This is for min peak global private equity in the term using as dry powder. The dry powder represents committed capital that hasn't been invested by the general partners. Back in near two thousand, IT was one hundred and fifty seven billion, but this year it's two point six three lion dollars.

In fact, the Manda drive powder went over one trying dollars in twenty fifteen and over two trillion dollars in twenty nineteen. Part of the reason that the amount of dry powder is increasing is there have been fewer exit over the last couple years for bio funds, for venture capital funds. So there have been fewer initial public offerings.

There has been fewer deals in terms of another company may be to private company buying the underline portfolio company. So you have had this back up of exits. Meanwhile, fn are still raising capital for new funds, and they're all trying to invest two dollars of capital either in the biot space, the growth capital space or the venture capital space.

In fact, some channel partners have launched continuation funds where they're launching a new fund to buy portfolio companies of their existing funds in order so the limited partners can get out. I mention these typical limited part partnership with seven to ten years, but there's typically language about extending IT, and that's what i'm saying in the fund of funds that i'm invested in because the underlying limited partnerships continue at the fund of fun level. They've had also extend in looking at my private equity portfolio, I mention i'm in six funds and they've done well.

I mention the wide range of returns within the private equity space. So generally speaking, the total value of pain capital for the funds are investing in. And i'm just focusing on the earlier funds that have vintage years of twenty eleven to twenty eighteen.

The total of pain capital has been around one point eight to three point one. Some of the venture did Better and not as well. Generally, the BIOS been around two, but they have meant expectations with internal rate to return fifteen eighteen percent。

Here's the thing though, they are incredible diversified. So each fun define or have just in the private equity space. So bio growth equity invention total about sixteen funds across the three categories, and that will represent close to three hundred positions.

So three hundred portfolio companies across the entire fund a fd, and that's important because some don't do very well. I was actually surprised. So just taking a look at the second fundament investment.

Sixteen funds, but three of them didn't make money over their life. In fact, two are selling for fifty percent below cost. So that's an actual fun. Now within the portfolio companies, some will have done incredibly well, others will have basically gone best.

And when you look at what does IT take to build out a successful private equity program as an individual investor or as an institution, the diversion diversification by fund, diversification by number positions, diversification by vintage year. I'm invested in six funds across twelve different vintage years. This was a long term commitment.

When I accepted my old firm, I decided, all right, i'm going to commit to this space, but it's gonna be very, very long term. And that's what other institutional investors do. And that's what becomes a real chAllenge for individual investors because it's incredibly difficult to get the type diversification we need because some of the portfolio companies will do incredibly well.

Some will be averaging someone to do well at all. On the same for the underlying flt as individual investors, most funds require us to be accredited investors. So for the U.

S, that means annual income between two hundred thousand for an individual, three hundred thousand combined with a spouse, or net worth greater than million dollars. Some funds require investors to be qualified to have a network of at least five million dollars. And then I don't have that.

And we mention that the best limited partners or institutional investors, they have access to the top to your front, whether and I don't know, through my old firm, they've develops 是 ships over decades and have access to some of these funds， but even some, they don't even now. And so when we think about how do we in individual, i'd say that i've gotten emma's like this on a new accredited investor. I want to get into the private equity space is difficult.

The one platform I found is called moon fair, that they seem to do good job building up diversification by find, but it's still early, so we don't know how their early funds have done. I'm involved in a appear group called long angle that sponsored broadcast for a while there, a group of high network individual investors. You have to have and think at least four million dollars of networks and they've gotten together and shared opportunities within their network that have created for investments in specific funds.

But typically the minim investment of just just one opportunities, one hundred thousand dollars. And most people just I said, I three hundred positions portfolio companies in the fun of fund structure that I am in which one fun. And so even doing individual deal, most people to still have the network to be putting one hundred thousand dollars in each opportunity and get the diversity you need.

I certainly don't have that. And so a lot of these platforms, such as our crowd, which is focus more inventive, capital IT is chAllenging to get the diversification you need. And given the wide range of potential returns within the portfolio companies, it's it's hard to make a case for why a typical individual investors should be invested in private equity.

Now there are newer platforms that allow people to invest in private stock of established companies given the the backlog of exit within the private equity space. And in terms of not they're not being as many ipos and companies are staying private for longer. There have been some platforms that have a risen the last four years, one as high, seven others equities, and that allows individuals to sell some of their stakes in a company they might be working for, where the the stock is a liquid is still a private company.

And as individuals, there is the potential to to buy that. Now again, it's really hard to get the diversification we need. If you're just this sort of a one off deal, kind of a flying speculative by any meter, then this question, what to pay for that you'll overpay for IT.

Interestingly, this year, there is a new closed and fund that was launched, the destiny tech one hundred tickers, D, X, Y, Z. They raised capital to buy stakes in the venture capital back companies that have been. Around for a decade or more in some period, and they'll putting together portfolio. So right now, they have twenty three private companies that they are top holding in space sex, thirty seven percent of assets, but they have small positions in OpenAI insta AR. And this is a liquid, closed and fun.

The chAllenge is, is selling at one hundred and sixty percent premium to its net acid value because this is one of a few ways for individual investors to get exposure to a little more diversification in the your capital space with talk to your companies, but you're paying a lot for that. And the only has twenty three companies at this point, and they charged two and a half percent annual fee. So when we step back then and think about the private equity asset, class words by up funds, venture capital, growth capital.

This has traditionally been an area that institutional investors have invested in for decades. They have the established relationships with the top to your funds. There is a wide range of returns between the top tier and the bottom tier funds. It's difficult as print visual investors to get access to the top tier funds and to have enough capital to build out a private equity portfolio consisting of hundreds of positions, which is really what you need in order to generate returns. Greater the public stock market, the access return for private equity on average has been greater than the public stock market, but not by that much.

And so other than maybe do some speculations on individual startups just for fun plan, losing all the money but at least learn, it's hard to make a recommendation to go into this asset class as individual investors is incredibly competitive. There's trillions of dollars of dry powder from institutions that is yet to be invested, and it's unclear when and if IT will get invest because there's always more funds. If you go back to, for example, two thousand seven was a year with the amount raised in buyout funds was higher than any year previously.

And it's a peak sort is similar to what being raised today, but IT was raised back in two thousand and seven. And then if you look at the returns of funds from that vintage year, some of the lowest returns ever in the biosphere. And so when there is a lot of dry powder, a lot of competition for potential deals, that leads to allow returns and his individual investors clearly disadvantaged in this space and is Better to focus on areas that doesn't have such a wide version of return.

So when you get access and that, that is the public equity market and in other asset classes that we've talked about, whether individuals we can get the same type of access as institutions, collateralized loan obligations, for example. This is something we've talked about in earlier episodes where now there are etf that allow us to invest in celo s, something that has traditionally been for institutional investors. Unfortunately, in the private equity space, those vehicles aren't there yet, at least at the feet levels that we're willing to pay.

And that gives us the diversification that we need to build out our portfolio. That's a look at private equity episode for ninety. Thanks for listening. You may be missing some of the best money for the rest of us content. Our weekly insider s guide email newsletter goes beyond what we cover in our podcast episodes and helps elevate your investment journey with information that works best in written in visual formats.

With the insiders guide, you can discover actionable investing insight provided only to our new other subscribers, unlock greater investing confidence with high value, snip its from our premium products plus membership and asset camp access exclusive news, offers an events you won't hear about anywhere else, further connect with the money for the restless team and community. And when you sign up, we'll also send you our exclusive investing checklist to help you invest with more confidence right away. The inside of guide is the best next step to get the most out of your investment journey.

If you're not on the list, go to money for the rest of us. Dot com and subscribed with to become a Better investor sign up box. Everything i've shared with you in the subsequent for general education, I have not considered your specific risk situation, not provided investment advice. This is simply general education on money investing in the economy. Have a great week.