Debt is cheap, cash is plentiful and life's exciting for private equity

Dania Zinurova

Wilson Asset Management

The Australian private equity industry has shown resilience through the challenges of the last two years and, with plenty of capital to deploy and debt at historically cheap levels, the long-term outlook remains supportive. 

Access to the asset class is often seen as the exclusive domain of large institutional investors, but that isn’t strictly the case. Here we look at some of the key features of the private equity asset class and the methods through which an Australian investor may access it.

What is private equity?

In some respects, there is little difference between investing in private companies and investing in publicly listed businesses.

Whether an investor has an interest in public or private equity, they are simply holding a stake in a business and therefore owning a slice of that company’s current and future profits.

Meanwhile, both public and private equity investors have been rewarded with higher long-term returns for embracing the higher risk associated with equity investments when compared to other asset classes such as bonds or cash.

Private equity tends to mean buying larger stakes in businesses, often owning a company in its entirety. Inevitably, this means being involved in the management and governance of that business, so it is a more intensive process which leads to higher associated costs.

Furthermore, private equity portfolios tend to be much more concentrated. Venture capital portfolios may be relatively diversified given the risks of investing in businesses at an earlier stage of their maturity. However, strategies targeting medium and large sized buyouts typically hold just five to eight companies.

Another key difference between private and public equity investing is liquidity. If you are owning stakes in publicly listed businesses, you can buy or sell your holding every day on the stock exchange upon which that company’s shares are listed. If you are investing in private businesses, however, you do not have access to that daily liquidity opportunity.

This feature presents advantages and disadvantages. It is positive because the lack of liquidity tends to lead to the opportunity for premium returns.

Private equity investors can command a better return for accepting the lack of liquidity on offer in the asset class. At the same time, it is a negative feature because it leads to exclusivity.

Investing in a private equity fund often requires quite a material capital commitment, usually $10 million as a minimum investment. Investing in private businesses directly requires even bigger ticket sizes.

Hence, the asset class is mainly the domain of institutional investors that control large pools of capital and can partner with private equity specialists, to gain exposure to the premium returns on offer.

Three things to consider in private equity investing

1. Megatrends

The lack of liquidity in private equity investing naturally lends itself to long-term time horizons. It is therefore of paramount importance that the macroeconomic fundamentals behind any private equity opportunity are strong and supportive of your investment thesis.

Megatrends are underlying macroeconomic shifts within societies and the global economy that persist for many years, if not decades, and they can represent supportive tailwinds.

Structural changes such as the ongoing digitalisation of our daily lives, climate change, globalisation and demographic trends, can provide compelling opportunities for private equity investors.

Indeed, because many of the businesses that embrace (and sometimes accelerate) these megatrends tend to be at an earlier stage of their maturity, opportunities are more prevalent in private equity and venture capital, than they are in public markets.

2. Debt markets

In the years leading up to the Global Financial Crisis, private equity had a reputation for a lack of financial discipline. Many private businesses took on too much debt and this over-leverage created problems during the financial crisis when debt financing dried up and demand collapsed.

Since then, private equity investors appear to have learnt from those mistakes and have become more disciplined in their use of debt. Leverage remains, however, with businesses owned by private equity tending to have more debt on their balance sheets than their publicly listed counterparts.

It is, therefore, very important that private equity investors maintain a close eye on bond market fundamentals. At the moment, these fundamentals are strong – debt availability is abundant, and the cost of that debt remains low.

These are healthy conditions for private equity investors, who can enhance the return they receive on their equity stakes by utilising this low-cost debt.

3. Risk/return characteristics

As with any investment opportunity, the risk and return characteristics on offer are of clear importance. Private equity investment is, by its nature, higher risk than many other strategies because of the lack of liquidity and the concentrated nature of portfolios.

The age-old relationship between risk and return means that this higher risk tends to be ultimately rewarded by a higher long-term return.

Within the private equity asset class, there are different risk/return profiles. For investors with a high appetite for risk, venture capital may represent an interesting part of the asset class.

Here, there tends to be a high degree of dispersion between winners and losers, but the returns seen on the earlier-stage winners are typically outsized.

For strategies targeting medium-sized or large company buy-outs, risks are more moderate given the maturity profile of the businesses being invested in, but long-term returns can still be attractive.

How can investors access private equity?

As mentioned above, with minimum ticket sizes of $10 million, direct investment in private equity simply isn’t an option for most investors. Furthermore, private equity investment requires considerable knowledge and skill, as well as capital.

Pooled funds, where capital from several different investors is collectively deployed, represents a slightly more accessible route, but the long-term nature of the asset class means capital may be locked up for six-to-eight years, which not all investors would be comfortable with.

The J-curve needs to be considered. This is a notable feature of the private equity asset class because of the length of time it takes to deploy capital within a fund. Money may be put to work gradually but management fees start to accrue immediately.

This often leads to an erosion of value in the short-term before the improving value of investments made can start to be reflected. Hence, the return profile can resemble the curve of the letter J, with a gentle decline slowly bottoming out, before a longer upward trajectory can be established.

The effect of the J-curve may be minimised by buying access to a private equity vehicle in the secondary market once it is already established and its capital has been deployed.

This is a popular route for gaining exposure to the asset class in the US and Europe but, unfortunately for Australian investors, the secondary market here is immature.

Other options include co-investment, where minority investments can be made alongside a private equity fund, or the multi-manager approach, where a portfolio manager builds a portfolio of individual private equity specialists.

Both of these routes remain prohibitive for the most investors, however, due to high minimum ticket sizes.

One final route for investors is to access private equity investment capabilities through a listed investment company, which is a type of collective vehicle that can be bought or sold on the Australian Securities Exchange.

This is perhaps the only option for the majority of investors to gain exposure to this asset class, as it removes the minimum ticket size hurdle. The illiquidity risk is significantly reduced, but investors continue to benefit from the skills and experience of a professional fund manager.

What is the outlook for Australian private equity?

There is currently a new generation of private equity investors establishing themselves in Australia, so this is an interesting time for the industry.

Many of these investors have learnt their trade at the bigger, established private equity houses, and are now setting up independently. This provides more opportunities to browse and a chance to pick the talented private equity investors of the future.

The opportunities within the venture capital part of the asset class are also looking very exciting.

For many years, Australian investors looked on in envy at the successful young technology companies being nurtured in North America, but now we have an increasing cohort of home-grown tech success stories, such as Canva, Shippitt and QuintessenceLabs.

Private equity investors have the opportunity to participate in this deeper opportunity set and the chance to unearth and nurture the tech success stories of the next generation.

In combination with a relatively benign economic outlook for the economy as a whole, and a considerable pool of capital ready to be deployed, these are exciting times for the Australian private equity industry.

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WAM Alternative Assets provides retail investors with exposure to a portfolio of real assets, private equity and real estate. The company aims to expand into new asset classes such as private debt and infrastructure.

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Portfolio Manager
Wilson Asset Management

Dania joined Wilson Asset Management in 2020 and is the Portfolio Manager for WAM Alternative Assets. Dania has held senior investment roles in Australia, the US, Europe and the UK throughout her career of almost 20 years and most recently held...

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