Asset Matters: The How’s and Why’s of Private Equity

At a time when investors are cautious about the return outlook for traditional public markets, private equity offers important long-term advantages.

The market environment is changing rapidly given tumultuous political events, shifting growth patterns and what they could mean for the future.  Low bond yields, rising rates and uncertainty over the duration of the current equity bull market are posing particular challenges. Together these influences are forcing many investors to look for “another way”—via alternative investment strategies that may provide different return patterns and thus help with diversification and return potential. Increasingly, private equity is a focus of this attention.

What is private equity? Simply put, it is an investment in a company that is not listed on a public exchange. Private equity (or PE)-backed companies are a growing presence in the marketplace, found across a wide spectrum of business sectors and stages, including start-ups, middle market and well-established enterprises. The number of U.S. private equity-backed companies has increased from roughly a thousand 17 years ago to more than 6,000 today, while the number of public equity companies has decreased by a third to less than 4,000.

Private Equity Companies Are a Growing Presence

U.S. Listed Companies vs. U.S. Private Equity-Owned Companies

Source: World Federation of Exchanges, Pitchbook, Bloomberg, NBER, Political Calculations: Doidge, Karolyi and Stulz (1975-2012), Wilshire Associates (2013-2015). *Represents all U.S.-based companies that are currently under majority ownership by a private equity sponsor. Includes only companies over $100 million.

Built-In Advantages

Private equity’s growing popularity is no accident, and seems driven by structural advantages afforded to PE managers, which may be best expressed in reference to stages of the investment process:

On the Buy: Unlike public markets, a private market investor may have information advantages, such as access to management and greater visibility into a potential portfolio company. The private equity market is also inefficient compared to public markets, and thus provides additional opportunities for attractive valuations.

During the Hold: The private equity investor has the ability to influence a portfolio company for the better—both in terms of operating improvements and positioning the company for growth.

On the Sell: PE investors have many potential exit options, including an IPO or sale of the portfolio company to a strategic or financial buyer. Importantly, private equity investors have the luxury of time. They're not managing to quarterly earnings, and can choose to exit at the most attractive time.

These advantages have historically translated into attractive performance and effective diversification. The asset class has outperformed the major public markets over the last 10- and 15-year periods with relatively low correlations to traditional asset classes. What’s more, over the last 25 years, the addition of an allocation to private equity has provided an improved risk/return profile for diversified portfolios (see displays).

PE Has Outpaced Public Markets

Comparison of Horizon Returns – Public vs. Private

Source: Thomson Reuters. Represents the investment horizon for Global Private Equity Index, as of June 30, 2016, which is the latest data available. Past performance is not indicative of future results. Indices are not available for direct investment. Please refer to the endnotes for certain important information on indices and risks of private equity investing.

PE Has Improved Portfolio Risk Profile

25 Years Ended 6/30/16

Source: Neuberger Berman, FactSet. Bonds represented by the Barclays U.S. Aggregate Index, stocks represented by the S&P 500, private equity represented by the Cambridge Associates Private Equity index. Past performance is not indicative of future results. Indices are not available for direct investment. Please refer to the endnotes for certain important information on indices and risks of private equity investing.

Types of Private Equity

Within the broad category of private equity, there is considerable variety and thus diversification potential. Key areas of investment include:

Buyouts: Investment in relatively mature, established companies, using a combination of debt and equity financing. This group is divided into small-, mid- and large/mega-cap buyouts:

Special situations. Involves restructuring of companies both from a financial and operational standpoint, and may involve the purchase of distressed assets or debt.

Growth capital: Typically working in partnership with a founder or entrepreneur, the private equity investor provides capital to help a company grow.

Venture capital: Investment in new, potentially high-growth, businesses alongside company management. Venture-capital financed companies may carry more risk than the other private equity segments due to the early stage of the business.

Private Debt: Investment in middle market companies that provide fixed income returns capitalizing on the illiquidity premium.

Depending on the investor, a core allocation to private equity may complement other alternative investments, such as real estate and hedge funds.

Liquidity Risk and Investment Flows

The process of developing and achieving a private equity investment thesis can take considerable time, which highlights a key issue with private equity: liquidity risk. Unlike public markets, where investors can regularly buy or sell their holdings, private equity has lockup periods that can typically last from 8-12 years. The tradeoff is that investors should be compensated for this illiquidity, which adds to the appeal of the asset class.

Another concern is the pattern of returns experienced by private equity funds, or what’s known as the “J curve.” In the course of a multiyear private equity commitment, investments do not occur all at once; rather, cash is “called” from investors as the manager puts it to work. In the first stage of the process, there are generally no distributions from the fund, and so the net return is negative. Later, as investments are realized, cash is returned to investors, and the fund’s cash flow profile should become positive.

Private Equity Investment Cycle

Internal rate of return of a private equity fund

Source: Neuberger Berman. For illustrative purposes only.

Allocating to Private Equity

As a general rule, private equity typically would represent a niche allocation within an overall diversified portfolio. For example, Neuberger Berman’s Investment Strategy Group typically recommends that high net worth investors with moderate to aggressive investor profiles invest up to 10% in private equity; individual needs vary—some may prefer to have more or less than this amount.

However, investors may wish to approach this allocation with the pattern of the J curve in mind. To offset the initial dip in cash flows early in the PE cycle, they may wish to regularly invest over multiple years. This helps to diversify by “vintage” (the characteristics of each year’s funds may be somewhat different). Moreover, investors often consider overcommitting to private equity to make sure they have sufficient assets at work. Typically, a fund will have about 60–70% of capital commitments invested at any given time, suggesting the need to commit 1.2 to 1.5 times the amount you want invested in order to achieve the desired exposure to private equity.

A related consideration is the high investment minimums that many private equity firms require of their investors. Private equity has traditionally catered to institutions and ultra-high-net worth individuals who can meet stringent wealth and income requirements set by statute. Only recently has the market been “democratizing” with the introduction of lower minimum strategies, including funds that have lower investor qualification requirements due to registration under the Investment Company Act of 1940. Even in that case, however, the minimums can remain quite high, meaning that the option of investing regularly may not be available.

What to Look For in a PE Manager

There are about 9,000 private equity firms in the space, with a wide disparity in terms of investment success, style and strategy. As a result, we believe having an effective manager is crucial, with differentiation boiling down to access, experience and results.

A PE manager should have access to a wide array of attractive opportunities (or “deal flow”) in order to be highly selective. It should be able to access information and resources needed to make well-informed investment decisions. Moreover, the manager should have an experienced team, with ample resources, that has invested across multiple asset classes and market cycles. Finally, it should have an attractive track record, both on an absolute basis and relative to peers. The strategy employed should not only have a history of success, but compare well in specific periods, given the market and economic environment.

Combining these elements will increase the chances of capitalizing on the unique opportunity associated with private equity.

Ways to Access Private Equity

Primary fund investment: An investor makes a commitment to a private equity fund that, via a general partner, makes investments in several companies. This provides diversification of underlying holdings across the private equity portfolio.

Fund of funds: In this case, an investor makes a commitment to a vehicle or a fund that in turn makes commitments to individual private equity funds. These commitments are typically quite diverse, with investments across managers and portfolios companies.

Secondary fund: In a secondary fund, the manager buys more mature or seasoned limited partnership stakes from other limited partners, often at a discount.

Co-investment: The investor makes an equity co-investment in an operating company, alongside the private equity manager, in a leveraged buyout, recapitalization, growth or venture capital transaction.

Other Nuts and Bolts

Structure: Private equity funds are typically structured as general partnerships, with the manager (or general partner) controlling the fund and often investing much of its own capital. The investors are limited partners.

Tax Treatment: Income, gains and losses from PE partnerships flow directly to investors for tax purposes, both in terms of amount and tax “characterization.” Depending on the underlying investments, this may affect whether they are suitable for use in an IRA or other tax-favored vehicle.

Tax Reporting: Private equity funds typically generate an annual Form K-1 for use in preparing income taxes, which usually takes longer to produce and may require that you file a tax extension. On the bright side, these forms can be aggregated in preparing taxes.

Costs and Fees: Most private equity funds charge a management fee of 1.5-2% on committed capital, with an additional performance-related fee component or “carried interest.” The latter is paid when returns exceed a certain threshold, thus providing a performance incentive to managers.

Note: Be sure to consult with a tax advisor before you invest.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. The use of tools cannot guarantee performance. Diversification does not guarantee profit or protect against loss in declining markets. As with any investment, there is the possibility of profit as well as the risk of loss. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

Important Information Regarding Investing in Private Equity

Prospective investors should be aware that an investment in any private equity fund is speculative and involves a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of such investment and for which the investment does not represent a complete investment program. An investment should only be considered by persons who can afford a loss of their entire investment. The following is a summary of only certain considerations and is not intended to replace any the materials that would be provided in connection with an investor’s consideration to invest in an actual Neuberger Berman private equity fund, which would only be done pursuant to the terms of a confidential private placement memorandum and other related material. Prospective investors are urged to consult with their own tax and legal advisors about the implications of investing in a private equity strategy, including the risks, and fees and expenses of such an investment which can be expected to reduce returns.

Market Conditions. Private equity strategies are based, in part, upon the premise that investments will be available for purchase at prices considered favorable. To the extent that current market conditions change or change more quickly anticipated, investment opportunities may cease to be available. There can be no assurance or guarantee that investment objectives will be achieved, that the past, targeted or estimated results be achieved or that investors will receive any return on their investments. Performance may be volatile. An investment should only be considered by persons who can afford a loss of their entire investment.

Legal, Tax and Regulatory Risks. Legal, tax and regulatory changes (including changing enforcement priorities, changing interpretations of legal and regulatory precedents or varying applications of laws and regulations to particular facts and circumstances) could occur during the term of a fund that may adversely affect the fund or its partners.

Default or Excuse. If an Investor defaults on or is excused from its obligation to contribute capital to a fund, other Investors may be required to make additional contributions to a fund to replace such shortfall. In addition, an investor may experience significant economic consequences should it fail to make required capital contributions.

Leverage. Underlying portfolio companies may have capital structures with significant leverage. These companies may be subject to restrictive financial and operating covenants. The leverage may impair these companies’ ability to finance their future operations and capital needs. The leveraged capital structure of such investments will increase the exposure of the portfolio companies to adverse economic factors such as rising interest rates, downturns in the economy or deteriorations in the condition of the portfolio company or its industry.

Highly Competitive Market for Investment Opportunities. The activity of identifying, completing and realizing attractive investments is highly competitive, and involves a high degree of uncertainty. There can be no assurance or guarantee that a fund will be able to locate, consummate and exit investments that satisfy a fund’s rate of return objectives or realize upon their values or that it will be able to invest fully its committed capital.

Reliance on Key Management Personnel. The success of a private equity strategy will depend, in large part, upon the skill and expertise of investment professionals that manage the strategy.

Limited Liquidity. There is no organized secondary market for investors in most private equity funds, and none is expected to develop. There are typically also restrictions on withdrawal and transfer of interests.

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