What is private equity?
Private equity is when investors buy into companies that aren’t on the stock market, help them grow or improve, and then aim to sell them later for a profit. It’s like fixing up a house to sell it for more—except with businesses instead of buildings.
It’s a world that private investors have few routes into, but it’s increasingly important they find a way. The number of companies listed on public markets in the US and the UK, for instance, has been in decline for decades.
At the same time some of the most innovative companies in the world are in the hands of private holders, often founders and exclusive bands of early investors. There’s also a whole world of other companies, from the small and growing to the more traditional that are privately held.
How does private equity work?
The world of private equity and venture capital is potentially a source of diversification and decent returns for investors, although it can be higher risk. The growth a company enjoys can be strongest in its pre-stock market life, if it ever lists on a market all. Yet most private investments are impossible for individual investors to access.
It’s not just earlier stage businesses. The stock market has been getting progressively narrower for some time. Research from fund manager Pantheon highlighted that over a decade the number of US and European listed companies has fallen 23%, while the number of private companies had increased by 74%.
Private equity holdings come in all shapes and sizes. There is just as much variety in the unquoted universe as the quoted one, if not more. Mature private businesses can also provide differentiation to what is available in the public arena. There is a big difference between an unproven blue-sky start up and mature companies that are privately-owned.
A route into private equity investment strategies
Investment Trusts can provide a gateway into the world of private investments, which is otherwise hard to access. It’s also an area where they can put their ‘permanent capital’ structures to good use.
Investment Trusts are companies listed on the stock market that invest in a specified area on behalf of shareholders. They can offer some important advantages over the main alternative, funds such as unit trusts and OEICs, because of their structure – a fixed number of shares that investors can buy and sell in the market.
It is inappropriate to include non-listed, private investments in open ended funds, i.e. where the size of the fund is variable, for anything other than exceptional and minor circumstances. This is because of their lack of ‘liquidity’ – the ease at which assets can be bought and sold – and the mismatch between this and the constantly changing size of assets under management.
With open-ended funds, a fund manager creates units for new investors and cancels them when money is taken out. Therefore, the fund grows larger as more people invest, and shrinks as they cash in. But when investors buy or sell the shares in an investment trust the trust’s assets don’t change.
This can offer several advantages. Having a fixed number of shares means there isn’t normally a need to buy or sell underlying assets to keep up with changing demand. This can allow a fund manager to be more fully invested as there is no need to keep some cash in reserve to meet redemptions. It also means investment trusts can be more appropriate vehicles to access more esoteric, illiquid assets that cannot be traded easily, such as commercial property, infrastructure projects, or shares in private companies. Having a set pool of assets means there is no need to engage in lengthy or expensive buying and selling to meet investor flows.
Why aren’t private equity investment trusts popular with retail investors?
Retail investors account for only 9% of private equity trust ownership, with institutional buyers dominating the share register at over 80%, according to AIC data. This is very different to the ownership of equity investment trusts where direct private investor ownership is much higher at 38%. Private equity trusts are not as easy to understand as those investing in listed stocks, but there is no reason why over the longer term they can’t produce returns of a similar magnitude – so why are they relatively unpopular with retail customers?
Firstly, there can be disadvantages of specialising in, or diversifying into, private equity. The area is notoriously sensitive to the economic cycle, interest rates and sentiment. This leads to a high level of uncertainty around valuations and volatility in investment trust share prices.
An added complication with private equity trusts is that underlying holdings may only be formally valued infrequently, sometimes as little as once a year. That means the stated Net Asset Value (NAV) is, to at some extent, backward looking – so investors need to factor in any movement, up or down, that might have occurred since.
Alongside complexity, the level of charges among specialist private equity trusts is typically off-putting. It’s more costly to run a private equity trust than it is to run one that invests in listed equities, so this is inevitable, but to some extent it can be made up for by trusts’ share prices, which tend to trade at a discount to NAV.
How do you invest in private equity?
While traditional private equity funds require a significant minimum investment, there are opportunities available for investors making modest contributions to their portfolio. Anyone can invest in private equity through investment trusts or other collective investments, such as an Exchange-Traded Fund (ETF).
One example of an investment trust is Pantheon International – a broad private equity-only trust offering a varied approach to the asset class. There’s a leaning towards more mature buyout and growth capital investments rather than early-stage venture capital, so Pantheon is likely to be a less volatile investment than others biased towards the latter.
The approach focuses on selecting experienced, well-resourced and strong performing private equity managers and maintaining a mature portfolio with exposure to different parts of the investment life cycle. Pantheon has a history of investing in private markets stretching back 35 years, which has fostered strong relationships with leading global private equity managers worldwide. Investors in the Trust therefore access a private equity portfolio diversified by manager, investment type, stage, geography, fund, vintage, and sector. Shares presently trade at a discount of 35% of stated NAV.
Meanwhile, there are broader trusts that invest in private equity companies, offering significant exposure to these assets as part of their portfolios. A standout here is Scottish Mortgage which presently has around 50 private company investments that account for about a quarter of assets. They include some large and well-known businesses including TikTok owner Bytedance and Elon Musk’s SpaceX.
The Trust remains an adventurous investment targeting the disruptive companies of the future, including some well-known private investments that would be otherwise be impossible to access. Clearly, there are very high risks involved with backing these types of companies and keeping to a sensible position size in a portfolio is of paramount importance.
Any investment capable of delivering outsized gains can deliver equally disappointing losses. However, as a modest part of a well-diversified portfolio we continue to believe it is a compelling proposition for the long term.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
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