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Private equity deep dive

William Craig, Investment Director
Mark Watson, Investment Specialist
2024-10-31
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Archived pieces remain available on the site. Please consider the publish date while reading these older pieces.
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Today’s private equity markets offer an increasingly wide range of potential investment opportunities with a similarly broad set of characteristics. In this paper, we explore four key questions to help investors better understand how these strategies compare and complement each other in a portfolio.

In particular, we compare two popular private equity investment strategies — venture capital and buyout — highlighting their distinct opportunity sets, risk-return characteristics, and portfolio roles.

What is private equity?

Investments in the global financial landscape can broadly be divided into public and private markets. The most prominent difference between these markets is that private investments involve financing nonpublic companies in negotiated transactions, unlike the easily accessible exchanges on which the public market primarily operates.

There are a multitude of different private market asset classes but the five most common are private equity, private debt, real estate, infrastructure, and natural resources. Each asset class provides a distinct investment profile due to different exposures, risks, structures, and target returns.

Private equity funds invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the fund intends to take private. They are generally structured in the form of partnerships that consist of investments in individual private companies. 

The types of private equity
Just as there are different asset classes in private markets, private equity is an umbrella term that describes a collection of unique strategies, such as venture capital, buyout, growth equity, fund-of-funds, and secondaries. The first three represent direct private equity investment strategies. Fund-of-funds are indirect investments and secondaries can be either direct or indirect.

  • Venture capital — Provides capital to new or growing businesses with perceived long-term growth potential.
  • Buyout — Invests in established companies, often with the intention of improving operations and/or financials. These investments often involve the use of leverage.
  • Growth equity — Provides financing to established and mature companies in exchange for equity (usually a minority stake) to help scale, expand into new markets, and/or improve operations.
  • Fund-of-funds — An investment vehicle that uses its capital to invest in other private equity funds. These structures allow for broad diversification across multiple managers but have the drawback of a double layer of fees, which impacts net performance. Fund-of-funds can either be focused on a single strategy (e.g., solely buyout funds) or diversified across multiple strategies.
  • Secondaries — The two types of secondaries funds are split into LP-led and GP-led transactions.
    • In LP-led transactions, an LP sells their interest in a fund. The buyer is typically a secondaries fund that resembles a fund-of-funds, as their portfolios are a collection of LP interests in different funds, with the primary difference being that they are typically more mature and can be purchased at a discount.
    • A GP-led transaction is instead initiated by the GP when a fund is reaching the end of its term. Instead of selling their remaining assets at a discount to wrap up the fund, a GP-led transaction, typically done through continuation vehicles, allows the GP to roll remaining assets into a new structure. Like LP-led transactions, these portfolios are more mature and closer to liquidity but differ in that they’re typically more concentrated and are not purchased at a discount.

Below, we dive deeper into venture capital and buyout strategies by examining their respective investment landscapes, risk-return profiles, and characteristics in a diversified portfolio. 

Figure 1

private-equity-deep-dive-fig1

Private equity opportunities

The characteristics of the companies that venture capital invests in vary significantly from those of buyouts. Generally speaking, venture capital target companies are high growth but unprofitable, while buyout target companies are profitable with stable reoccurring revenue but have more moderate growth.

The venture capital opportunity set
Venture capital is itself a broad strategy that is most frequently divided into the substrategies of seed-stage venture capital, early-stage venture capital, growth-stage venture capital, and late-stage growth (also known as late-stage venture capital).

Seed-stage companies typically require financing to research business ideas, develop prototype products, or conduct market research. Early-stage companies generally have well-articulated business and marketing plans but are pre-revenue. Growth-stage companies have started their selling efforts and need capital to expand production capacity, product development, and/or fund working capital. Late-stage growth companies typically have a product or service that has achieved relative maturity and are raising additional capital to fuel further expansion or accelerate growth before a liquidity event, either through an IPO, strategic buyer (M&A), or financial buyer (commonly buyout funds).

Venture capital firms generally raise funds that focus on one of these exit substrategies, although it is also common to raise diversified funds that invest across two or more.

The buyout opportunity set
Buyout funds typically invest in profitable companies with steady cash flows that can bear leverage. These funds target companies to which they believe they can add value through operational improvement, cost cutting, M&A, leadership changes, and/or financial engineering. The size and financial profile of the companies that buyout funds target varies depending on the substrategy. These are typically divided into lower market, middle market, and mega market.

Given that buyout substrategies are fairly consistent, with the major difference being the size of the company, the rest of this paper considers buyout as a whole compared to early-stage venture capital and late-stage growth. 

Private equity’s risk-return profiles

Investors allocate to private equity in pursuit of higher returns and diversification. This is for good reason, as over the last 25 years, the Cambridge Associates Venture Capital and Buyout Indices returned pooled net returns of 19.35% and 12.82% respectively, compared with annualized returns of 6.73% and 7.39% for the Russell 2000 and the S&P 500 indices, respectively.1 Importantly, private equity investments, as noted in our previous piece on Understanding private equity performance, are typically measured using performance metrics that are unique to these funds.

While the historical premium to public markets is attractive, allocators to early-stage venture capital, late-stage growth, and buyout should consider the distinct risks associated with these investments.

  • Early-stage venture capital’s most prominent risk is “operational risk,” which is the possibility that the companies they invest in could fail due to an inability to execute their business plans.
  • Late-stage growth’s operational risk is mitigated at this stage due to the size of the companies, which now instead face “valuation risk.” This is the risk of overpaying for an investment and being unable to make a profit in liquidation.
  • The buyout strategy’s biggest risk is the very same leverage that can result in strong returns. The resulting “financial risk” for buyout is the risk that the company will not be able to service or pay back the debt used for the investment, which may result in a partial or complete loss of investment.

Early-stage venture capital and late-stage growth funds rarely lever their investments, making them less vulnerable to financial risk and higher interest rates. All three strategies bear illiquidity risk as they cannot exit their investments when it may be most convenient and instead require a liquidity event. Despite these risks, investments in these strategies can yield important diversification benefits that can help “de-risk” a portfolio. Figure 2 shows the potential risk-return profile for each strategy.

Figure 2

private-equity-deep-dive-fig2

Bottom line: Where does private equity fit in a portfolio?

Early-stage venture capital, late-stage growth, and buyout are three of the most common strategies in private equity. Many investors in this asset class allocate to buyout as a core holding given its moderate risk level and relatively stable returns, while investments in early-stage venture capital are frequently smaller and seeking outsized returns. Late-stage growth is relatively new compared to the other two strategies, but its risk profile and potential for quicker return of capital may be attractive to investors implementing exposure to venture capital at scale, building a new private investment program, or as an alternative to public equity small-cap strategies.

The combination of early-stage venture capital, late-stage growth, and buyout allows investors to allocate across a business’s life cycle (Figure 3), improving exposure and diversification. In addition, private equity investments historically have not been as correlated to downturns in the public market, so they have the potential to stabilize a well-diversified portfolio during these times.

Potential return, risk, and liquidity expectations are critical considerations for investors allocating to private equity, with the best diversification benefits historically having been achieved by investing across strategies. For this reason, many institutional investors have separate allocations to each substrategy.

Figure 3

private-equity-deep-dive-fig3

1 Source: Cambridge Associates US Private Benchmarks Q1 2023 Report. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Please refer to the end of the document for additional disclosures.

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