One of the primary drivers for investing in private equity is increasing portfolio returns. Studies indicate that adding PE to traditional asset mixes such as stocks-bonds can significantly enhance risk-adjusted returns over the long-term.
Understanding private equity’s unique return drivers and challenges is vital. Here, we explore four key components.
Increased Returns
Private equity can produce higher returns over extended timeframes than public equities.
Private equity offers numerous potential advantages over public equities when it comes to investment returns, including lower volatility compared to public markets and its focus on operational improvements and value creation, non-correlated asset classes and providing higher return levels over extended investment horizons.
Private companies do not face as many financial reporting and disclosure regulations, making them easier to quickly respond to market conditions that may impact overall performance and present investors with opportunities.
Private equity managers can claim interest payments on debt as deductions against taxes, similar to what households do when taking out mortgages. This helps lower their effective tax rates – something especially valuable given that PE firms typically possess significant leverage.
Greater Diversification
Many private equity investments span across industries, providing investors with more opportunities to diversify and mitigate risk. Private equity firms utilize various growth strategies that differ significantly from what public companies typically implement when buying to sell shares publicly; because of this variance, private equity tends to have lower correlations with public stock markets and may respond differently during expansion/recovery cycles than traditional stocks.
PE managers also can take advantage of debt financing to reduce their equity commitment and leverage their investment in an acquired company, thus decreasing their exposure to price volatility, making it easier for them to generate attractive long-term returns.
Defenders of private equity assert that its ability to infuse capital into struggling companies and save them from bankruptcy while safeguarding jobs is integral to our economy. Furthermore, tax reform which aligns carried interest with ordinary income taxes would significantly boost private equity’s competitiveness.
Lower Risk
Private equity can provide long-term investors with significant returns; however, understanding its associated risks is key to realizing these positive results.
One of the primary risk factors associated with PE funds is their high investment minimums, which restrict access for many investors. Furthermore, their “J-curve” can result in negative net returns early on due to cash calls being called in from other funds in order to fund new ones – another potential complication of investing.
One major risk associated with PE funds is their higher borrowing costs, which decrease their overall return potential. To reduce this risk, ensure proper manager selection, broad diversification and appropriate allocation to this asset class in your portfolio.
Higher Liquidity
Traditionally, private equity investors have focused their attention on leveraged buyouts of asset-intensive companies at discounted valuations. But with recent changes to investment strategies, their focus has broadened to encompass both early-, mid- and late-stage growth opportunities as well as turnaround situations.
As such, private equity fund returns can vary considerably; however, according to a recent Pantheon study including private equity in an otherwise pure public equity portfolio could open up an estimated 3.16 percent annualized excess return (commonly known as “alpha”).
Private equity typically boasts the highest expected long-term return among alternative investment classes, surpassing real estate and bonds. Although this high performance demonstrates how valuable private equity investments can be for creating jobs and improving our economy, policymakers should carefully consider how subsidized tax incentives could impact this industry in the longer run.
