JARGON BUSTER: PRIVATE EQUITY
Roy Davidson, 22 February 2021
What is private equity?
Private equity is as simple as the name suggests – it comprises investment into a company that is not publicly listed and traded. As an asset class, private equity typically encompasses investment funds that will buy companies, or stakes in companies, to generate a return for their investors.
The world’s largest private equity company is Blackstone with a portfolio just shy of US$100 billion. Other large firms include The Carlyle Group, KKR, and TPG Capital. Locally, well known private equity firms include Direct Capital, Pencarrow, Pioneer Capital and Waterman Private Capital.
Private equity is often the step before listing
Companies owned by private equity funds, especially in the New Zealand context, are usually smaller than those listed on public markets, and are commonly at an earlier stage of their life. A private equity firm may invest in these companies, providing them the capital they need to grow, along with their expertise. Private equity therefore fills an important role in our capital markets.
Some examples of smaller companies currently owned or part owned by private equity firms are Rockit Apples, The Collective, Tom & Luke, and LayBuy.
As they become bigger, the private equity firm will often look to make a sale and look for other opportunities. This can be done a few ways – either a trade sale to an acquirer, or by listing it on the stock exchange via an initial public offering (or IPO).
Some of New Zealand’s most successful listed companies have been owned by private equity at one point in their history. For instance, before listing in 1999, Ryman Healthcare was part-owned by private equity. Similarly, Scales, though having origins stretching back more than 100 years, was owned by private equity for a period before being listed in 2014.
Private equity firms may look to improve performance of a company
Another common approach used by private equity firms is to look to invest in underperforming businesses (which may have been publicly listed) and improve their operations, thereby generating greater cash flows and providing a return for investors.
This approach is a bit more controversial and much more common overseas than in New Zealand. If a private equity firm has achieved the increase in profits by essentially cutting costs in the business, this can sometimes lead to skepticism from potential future buyers about whether profit margins are sustainable. Similarly, a private equity firm may restructure a company, splitting it into different parts and selling them in an attempt to realise value. Again, this is uncommon in New Zealand.
How does it work?
Private equity works a bit differently to other investment funds most investors will be familiar with.
In the most common structure used in New Zealand, an investor will commit to providing a set amount of money over a set period of time. As investment opportunities arise, this money will be ‘called’.
For example, say you commit $1 at the beginning, 20 cents may be called in the first year to invest in a new business. Then another 20 cents may be called in year two, for example, followed by the remainder in the following years. This allows private equity managers to wait for the right opportunities.
What are the advantages and disadvantages of private equity?
For an investor, the main advantage of private equity is it provides access to a part of the market they wouldn’t otherwise have access to. As this part of the market is less readily accessible, it can potentially provide opportunities for above average returns. It can also open up a different range of companies and industries than are listed on the NZX. Around 85% of New Zealand’s GDP is derived from private companies and over 70% of our largest 200 companies are private.
However, private equity is somewhat less liquid than investing in public markets. If you invest in a private equity fund, your money is usually tied up for a number of years with a reduced ability to sell your stake. This contrasts with most funds or listed companies where you can sell at virtually any time. As a result, investors should take a long-term approach to private equity investments. There are also typically minimum investment amounts, while funds may be restricted to wholesale investors only.
As many of the companies private equity funds invest in are smaller and in an earlier phase of their life cycle than public companies, they can carry higher levels of risk. Meanwhile, due to the hands-on nature of private equity ownership, fees tend to be a bit higher than conventional funds. Disclosure requirements are also less fulsome.