Our friend asks us: should I move my investments to private capital markets?
The reason behind this question lies usually in the expectation of higher returns[1], so it will be better to do a little analysis before answering it.
The fundamental difference between public and private capital markets[2] is their regulation. Public markets are highly regulated, seeking to protect the smaller investors. In contrast, private markets are less regulated because they are not massively promoted and are aimed at more sophisticated investors.
In recent years, access to private capital markets through private equity funds has become popular.[3] These funds have been established by an operating partner, in charge of selecting and managing the investments, and financed mostly by passive investors. Regulation for these funds is limited, including in key areas such as investment liquidity, available information, valuation rules, etc.
Operating partners are usually specialized firms that include experts in the different target industries, who provide their access to investment opportunities and their ability to evaluate them. Once the investment is made, the operating partner usually gets involved in the management of the acquired company to influence their growth or recovery. For this reason, acquired companies often see major changes in their strategy and operation. Operating partners have an active, specialized and fundamental role in the value generation, so compensation that is proportional to their effort and achievement could be justified.
Additionally, private equity funds usually have a predetermined life, that is, the investments will be eventually liquidated to realized gains, net assets will be distributed, and ultimately the fund will be dissolved. Investors are then invited to participate in a new fund.
Private equity funds are classified according to their objective. Venture capital funds (VCs) focus on relatively new companies with high growth potential. Growth funds focus on companies with proven business models but requiring capital to grow. Buyout funds (or Leveraged Buyout Funds) are dedicated to acquiring existing companies representing an opportunity to increase their value. Distressed or turnaround funds specialize in buying companies that are having difficulties restructuring them.
In view of the above, the answer to our friend would have these dimensions:
– It would be necessary to determine if our friend qualifies, according to his type, assets and income, to be able to acquire a private equity fund.
– He should be alerted to the lower regulation in this type of vehicle, which implies that the responsibility for due diligence lies in his hands.
– It should be explained that the liquidity of a private equity fund is not daily[4], as we are used to in public capital markets, and therefore it is necessary to evaluate what percentage of the total portfolio can be committed for a potentially long period of time[5].
– It should be made clear that there is a great dispersion between the results obtained by high-quality operators, capable of finding good opportunities and transforming them into reality, and those of others who are less capable. A good selection could make a big difference.
In conclusion, access to a universe of issuers that are not listed on stock exchanges, the implicit premiums in purchase prices due to the illiquidity of the investment, and the active management of operating partners, have shown that private equity funds can be a good complement to traditional portfolios. However, and because it is a different and complex product, it is necessary and important to understand very well its nature and its role in each investor’s portfolio. A qualified investment advisor can help determine the viability, as well as in the selection and integration of these types of investments.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] Historically, the median return of private equity funds has been higher than that of investments in traditional funds. However, the dispersion of results has been much wider.
[2] By public markets we refer to investments in securities subject to public offering, that is, open to the public. Stock exchanges are an example of a public market. Private markets refer to offers aimed at very small and/or more sophisticated groups.
[3] Private debt or private credit funds follow a similar concept, but they make loans instead of acquiring shares.
[4] The absence of daily liquidity has to do with the fact that the underlying assets are not listed on stock markets, which also does not allow market valuations to be obtained.
[5] It is to be expected that in times of crisis not only could the valuations of the underlying assets fall, but also the number of people interested in acquiring a stake that the fund put up for sale would decrease.