Private equity, without the barriers: How ETFs are opening the door

Private equity continues to attract investors’ attention. The reason is simple. For the last few decades, this asset class has yielded increased returns for many institutional investors by capitalising on opportunities to harness substantial growth and enhance the efficiency of established businesses.

But many investors think that access to these opportunities is beyond their reach.

It is well known that many private equity investments have barriers to entry, often requiring large initial investments, multi-year financial commitments, an extended lock-up period before full capital deployment, illiquidity, and limited transparency.

There is a way, however, to participate in this asset class via ETF's. By investing in the stocks of publicly listed companies that specialise in private equity, investors can gain access to the realm of private equity while also avoiding the drawbacks associated with the asset class.

Private Equity

Private equity is ownership or interest in a corporate entity that is not publicly listed. There are different types of private equity investments. It can involve taking a stake in a growing business, making direct loans to a business, or it can be taking control of a company either through outright purchase or through obtaining a controlling equity interest (buyout). Private equity provides capital to nurture expansion, fund new products or restructure to unlock greater value for investors.

And private equity is growing.

According to consultancy firm Bain, “the number of US public companies has declined by about a third over the last 25 years, and the remaining pool is dominated by a handful of large tech firms that hold disproportionate sway over the indexes. That makes it increasingly difficult to find adequate diversification in the public markets. Private market returns, meanwhile, are outpacing public returns over every time horizon, while alternative funds provide access to the broad global economy and the fullest range of asset classes. These advantages explain why private markets continue to grow relative to the public markets.”

Another consultancy firm, McKinsey & Company, highlighted that private equity have grown at a compound annual growth rate (CAGR) of 13.6%.

Chart 1: Assets under management for closed-end, commingled private equity funds.

The difficulty of access

Traditionally, direct investments in private companies and in the private equity funds included in Chart 1 require:

• large capital outlays,
• long lockup periods, and
• investors taking a concentrated, illiquid exposure to a small number of private companies – which are often leveraged.

It is that last point that has been the subject of debate recently. The two most important points to remember about liquidity are:

• Its definition – a liquid investment can be readily acquired and converted to cash.
• The impact on price – a liquid investment can be bought or sold at a fair value without a significant premium or discount to its fair value. An illiquid investment may need to be sold at a discount to be readily converted to cash.

The illiquidity premium of private equity

By investing in private equity, large superannuation funds are potentially being ‘rewarded’ for illiquidity. They are locking up their investment for a long period of time, in the hope that their private equity investment comes to fruition. The illiquidity premium is the additional returns an investor can capture from locking their money up for a longer duration than if it was sitting in cash or public markets.

The J-curve illustrates this.

Chart 2: The private equity J-Curve

If the business matures, it typically requires less capital. Cash flows increase and eventually, it starts to return income to investors represented above as distributions. Over this time, the value of the private equity investment also increases. The return line is sloping upwards. In the hypothetical example above, by year 10, the investment may be more liquid, in other words, someone might be willing to pay close to fair value for the asset.

This doesn't mean there are no ways to exit a position in the private markets at any time, but investors often can’t get out quickly and will need to sell via a secondary market to a buyer willing to buy their asset. This contrasts with listed securities that can be easily bought and sold on an exchange.

Investing in private equity, while potentially rewarding, is risky and the recent market volatility has bought this to the fore for Australia’s largest superannuation funds.

Risks of private equity investing

The increasing allocation by large super funds into unlisted private equity assets is problematic for two main reasons:

1. Price disclosure and valuation, there is no price visibility for members of the fund over the value of private equity assets held. Valuations are subjective and infrequent.
2. Liquidity risks for those funds making high allocations to illiquid assets.

Price disclosure and valuations

The first problem with allocations to unlisted private equity is that prices are not easily observable, valuations are opaque, subjective and infrequent. The lack of market prices can result in opaque valuations, which can misstate investment or fund values. As a result, members may never know the value of unlisted assets in their super funds. For example, overvaluing a private equity investment could potentially have an overstated impact on investment returns.

The Australian Prudential Regulation Authority (APRA) undertook an unlisted asset valuation thematic review in 2021, which found superannuation funds’ revaluation frameworks need improvement. The findings included that board engagement was often limited, and some trustees relied overly on external parties. The regulator has called upon super fund trustees to improve the frequency and methodology used in unlisted valuations.

In February of this year, ASIC released a discussion paper on private and public capital in Australia, which resulted in over 50 submissions. ASIC Chair Joe Longo said the agency was closely considering the submissions to inform its next steps.

‘ASIC has a mandate to drive financial system performance and improve investor confidence,” Mr Longo said.

Despite the risks discussed above, the appeal of private equity as an asset class remains. We think investors can gain access to this market without sacrificing liquidity via listed private equity.

Listed private equity

Listed private equity companies, that trade publicly on exchanges around the world, gain their exposure to private equity either:

• directly, that is the company invests directly in private equity from its own balance sheet;
• indirectly, by investing into private equity funds; or
• they are the private equity managers themselves.

Listed private equity can provide investors with similar exposure to the benefits of unlisted investments in a more transparent, lower cost, and accessible way.

The LPX50 index, which includes the largest and most liquid 50 private equity companies giving investors exposure to venture, growth and buy-out opportunities. You can see from the chart below, why large institutions continue to invest in private equity.

Chart 3: 10-year hypothetical performance: The listed private equity index has outperformed other asset classes

Traditionally only the largest institutions have had the resources to build a diversified portfolio of private equity funds. Now you can too.  For investors looking to access private equity without locking up capital for years or facing high minimums, listed options are emerging as a viable alternatives.

ETF

VanEck Global Listed Private Equity ETF (GPEQ)

Alternative Assets

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