Investors can usually easily buy shares and bonds listed on exchanges around the world, but what about investments that aren’t traded on public markets? Stock markets don’t have the monopoly on investment opportunities. On the contrary. Some of the fastest growing companies and investments are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies.
In the era of increased digitalisation, having access to these types of investments seems more important than ever. Some of the most innovative companies in the world today are private businesses, often because they are technology-based and have lower costs meaning there is little need to raise capital via the stock market to grow. Many sub-sectors across various industries are not well represented in public markets.
In fact, the stock market has been getting progressively narrower for some time. In a recent report, fund manager Pantheon highlighted that over the past 10 years, the number of US and European listed companies had fallen 23%, while the number of private companies had increased by 74%.
Private investments are often impossible for individual investors to access except, in some cases, for high net worth people able to invest high minimum amounts. However, there is a gateway for ordinary investors through private equity funds. Although the area can be higher risk, it is potentially a source of decent returns as the growth a company enjoys can be strongest in its pre-stock market life – if it ever lists on a market all.
How private equity works
Private equity fund managers are known as general partners or GPs. Typically, they form limited partnership vehicles to invest in private companies. Investors commit a specified amount of capital (for instance $10m minimum) to a private equity fund to become limited partners or LPs. These limited partners include pension funds, sovereign wealth funds, insurance companies and endowments.
General partners typically invest their own capital alongside limited partners and aim to maximise returns on their investment in the business through a close relationship with the investee company. They will generally seek to help optimise operational performance, financial structure, technology enablement and management team structure and depth. Depending on the circumstances, they might also encourage product innovation, expansion into new markets or a strategic acquisition to add value.
Private equity investments can take the following forms:
- Direct Investment - Private equity in its most simple form is direct investment into a company. Very few investors have the size, sophistication and resources to make direct investments, but if done well it can generate the most attractive returns.
- Primary Fund - This is the most prolific form of private equity investment. Investors (LPs) commit capital to a primary fund which is established by a General Partner to identify and invest in private companies. LPs will typically pay management fees and performance fees.
- Secondary Fund - Investors commit capital to a secondary fund which identifies and buys interests in existing primary funds from other investors. The buyer replaces the seller in the acquired primary funds. Usually, the primary funds are largely or fully invested, so acquired assets are generally known at the time of purchase.
- Co-Investment - Investors invest alongside fund managers directly into companies. The fund managers retain a decision-making role for both the business development and investment exit, so the investor is effectively a passive partner there to help provide the initial capital required.
- Fund of Funds - identifies and invests in several primary funds over a predetermined period. This mitigates portfolio concentration of a single period of deals (or ‘vintage’) and can provide diversification at a lower minimum investment.
Private equity investment trusts
Investing into earlier stage investments can be risky, and later stage private companies’ plans can go wrong too. Creating and enhancing value also takes time. Broadly, there is the initial fundraising (one year), the investment period (4 to 5 years) and finally the ‘harvest’ period (6 to 10 years). Investors are therefore required to lock up capital for an extended period, which is why they tend to demand a high return or ‘risk premium’ to make it worthwhile.
Yet there is a way for ordinary investors to harness the asset class while maintaining access should they wish. Private equity investment trusts offer exposure to the area and shares can be traded through the stock market like any other share. They also maintain a broad and diversified approach, so investors are not reliant on too few companies or sectors, or a narrow period in which initial investments are made.
The underlying investments are illiquid, which is why an investment trust structure, with a defined amount of capital under management, is ideal. Closed-ended funds do not have to sell the underlying assets and investors can exit whenever they want to, in contrast to open-ended funds which would be unsuitable for private equity investing.
Our pick for a specialist fund in the area
Pantheon International investment trust (PIN) has a portfolio roughly split evenly between primary, secondary and co-investments with a focus on small and mid-market buyout and later stage growth capital investments. Early-stage venture capital activity is generally considered to be too protracted, and this type of more risky investment is mainly through primary fund investments with top-tier venture managers.
The depth and expertise of the investment team combined with the broad nature of the underlying portfolio and solid long-term track record makes this a worthy consideration for exposure to the asset class in our view, although past performance is not a guide to the future. The approach focuses on selecting experienced, well resources and strong performing private equity managers and maintaining a mature portfolio that has exposure to different parts of the investment life cycle.
Pantheon has a long history of investing in private markets which stretches back 35 years. This has fostered strong relationships with leading global private equity managers worldwide. Investors in the Trust therefore access a portfolio diversified by manager, investment type, stage, geography, fund, vintage and sector.
When looking at co-investments the team focus on an assessment of the company’s business model and competitive position, value creation drivers, capital structure, valuation and return profile. These made up less than 20% of the portfolio in 2015, but today they comprise over a third. We expect this to continue to rise amid a shift an increase in younger vintage investments (the average age is 5.2 years presently) and a skew to the education, healthcare and technology sectors. Co-investments also tend to help lower fees, which alleviates some of the concerns about high charges associated with the area.
The ‘sweet spot’ for Pantheon’s co-investments is between $30m to $50m which tend to fly under the radar of the larger pension funds and endowments. Within the healthcare space, a co-investment in Kersia (provider of biosecurity, disinfectant and hygiene solutions) with IK Investment Partners (Nordic private equity group) and one into US healthcare company NAMSA (provides outsourced R&D) with ArchiMed (healthcare private equity specialists) have been recent highlights.
A conservative approach to valuing the Pantheon portfolio has resulted in significant uplifts on the disposal of holdings in the portfolio historically, but investors need to commit for the long term, be patient and understand the performance journey will likely not be a smooth one. Very sharp falls in the share price in 2008 and, to a lesser degree, in 2020 show that sentiment towards the asset class can play a significant role in the short term, though to be fair those occasions were extreme events and the current discount to net asset value of around 15% provides some comfort that could be value from this point.
In recognition of the increasing number of opportunities in the world of private investments, as well as the broad nature of the Pantheon portfolio and the quality and record of the management team, we add the Trust to our ‘Preferred List’ which is designed to highlight strong fund options for new investment in their respective sectors. It could offer important diversification and potential for long term growth in an equity portion of a portfolio.
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