portfolio construction
Adobe stock / master1305

As an asset class, private equity has become more mainstream in the past 10 years thanks to a broadening investor base, improvements in accessing the asset class and increased allocations among investors due to strong returns and ongoing volatility in public markets.

While private equity investing has been around for decades, many new investors are less familiar with what goes on within the asset class. There are three broad private equity segments, each with different risk and return opportunities.

The venture segment focuses on earlier-stage companies that come with higher risk, minimal profits and more volatility in their return potential. The growth segment is more established than the venture model and typically generates revenues and earnings, but these companies still require significant investments of capital to scale their businesses. Finally, the buyout segment encompasses well-established businesses that tend to be far less risky because they’re generating cash flows year in and year out, but still benefit from investor capital to advance a specific targeted business plan.

These segments experience different trends over time as capital and liquidity conditions in the markets evolve. With the recent emergence of higher interest rates, inflation and sustained uncertainty across the market, gone are the days of ultra-low borrowing costs and the associated sky-high valuations for riskier venture and growth companies. Investor attention and capital flows have shifted from the venture segment into buyout, toward companies that are already profitable, are generating free cash flow and have already proven to be viable.

In addition to different segments within private equity, there are also different ways to invest in private equity, including direct, primary and secondary investing.

With direct investing, the investor purchases equity directly in a private company. In primary investing, a private equity manager puts together a fund and collects money from investors to buy a group of private companies. The investor becomes a unitholder in that fund and benefits from the actions of the private equity manager who manages, grows and transforms the private companies within that fund. Finally, in secondary investing, the investor buys another party’s primary investment in a fund partway through the fund’s value creation cycle.

Along with the shift toward the buyout segment of private equity markets, there has been rapid growth in secondary investing, driven by the overall growth of the private equity landscape, a slowdown in initial public offering activity in 2023, volatility in the public markets and the ongoing desire of private equity investors for liquidity. This has created a fertile environment for managers skilled in navigating the opportunities currently on offer in the private equity secondary market.

Considering all this, there is a tremendous opportunity for advisors to help their clients take advantage of this transition and pivot their investments toward the parts of the market that are on the rise and are likely to sustain performance as long as interest rates remain elevated, which is expected for the foreseeable future.

Benefits of private equity

Historically, private equity has offered a return advantage over public markets. This asset class has delivered mid-teen annual returns — several percentage points ahead of public equity markets — over the past quarter century.

Additionally, private equity has been an attractive option for investors because it comes with lower volatility, especially when markets are weak and public markets are falling. This is in part because private equity is usually valued only once per quarter, providing less motivation for investors to sell at inopportune times and locking in losses.

Investors can also find more investment opportunities because the world of private companies is considerably larger than the public sphere. In fact, over 97% of companies above $10 million in annual revenue are privately held and hence impossible to invest in via the public markets.

Finally, private equity can bring more diversification benefits to investors’ portfolios because there is less correlation to traditional asset classes, potentially resulting in a more balanced and well-constructed portfolio over time.

Understanding liquidity in portfolios

Advisors should help their clients understand that one of the main differences between private and public investing is the amount of liquidity available.

Unlike in public markets, investors do not have the flexibility to immediately sell their stock in private equities and move on to a different investment. Traditional private equity funds are structured as closed-end funds. Investment capital is raised during an initial fundraising period and called from investors as opportunities are identified. Private companies are bought, improved over time, and sold at a (hopefully) significant profit five to 10 years later. Through this process, investors achieve liquidity over a longer period, as companies are sold following value creation and capital gains are returned to investors periodically throughout a typical 10-year fund life. A properly diversified fund with many companies held by several private equity funds offers the best chance of regular liquidity for investors.

This means advisors should make their clients aware that this asset class is best suited for investors who have a longer time horizon, as their ability to redeem their funds will be limited. The upside, of course, is that this limited liquidity is generally compensated for by a higher expected return — also known as an “illiquidity premium.”

With private equity growing in demand so rapidly, this asset class is becoming impossible for advisors and their clients to ignore. To ensure clients’ portfolios remain diversified, it is important for advisors to be aware of and up to date on the evolution and opportunities that exist within the space and to identify managers and strategies that can effectively capitalize on these trends.

Allan Seychuk is vice-president and senior investment director with Mackenzie Investments.