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What Is Private Equity?

Private equity is the ownership of shares or other equity or equity-like interests in companies that do not trade publicly on a stock exchange, or over-the-counter, among investment dealers. As there is no instantaneous market for trading, these investments are appropriate only for patient investors with a long-term view.

Because the investments often involve the acquisition of a controlling interest or significant influence costing several millions of dollars, private equity opportunities are generally more appropriate for large institutional investors with the time and resources to evaluate the potential risks and returns, and the patience to wait 10 years or longer to maximize investment returns.

Performance of private equity vs. public equity
Period ending September 30, 2004

Asset Class Index/Proxy Annualized Rate of Return (%)
    1 Year 5 Years 10 Years 20 Years
Canadian public equity S&P/TSX Composite 18.85 6.20 9.03 9.35
U.S. public equity S&P 500 6.79 -4.21 10.44 12.57
NASDAQ -0.34 -9.73 8.93 10.48
Russell 3000 6.71 -3.12 10.18 12.28
Russell 2000 10.93 4.09 9.12 10.38
Private equity* Buyouts 23.7 3.1 8.5 12.7
Venture capital 7.4 14.4 26.7 15.6
All private equity 18.8 5.7 12.9 13.7

* Venture Economics US Private Equity Performance Index in USD as of June 30, 2004

The performance table shows that over the short term public and private equities can have wide swings in performance. Over the longer term private equity can generate superior performance compared with public equity. The TSX Composite Index is the broadest measure of public equities in Canada. The S&P 500, NASDAQ, Russell 2000 and 3000 indexes in the U.S. are reasonable public market proxies for companies in the private market. The private market proxies for private equity buyout and venture capital funds are developed by Venture Economics, a U.S.-based provider of performance data on the private equity industry.

Types of investments

There are basically three types of private equity investments:

  1. Venture capital, principally in early-stage companies that are still developing their products or services, yet have the prospect of generating revenue in a few years; and later-stage firms generating revenue with the expectation of profits within a year or two.
  2. Buyout and acquisition financing, usually accompanied by a new business plan, and occasionally with new management, to improve a company's financial performance.
  3. Expansion or merchant banking capital to established companies looking to enter new markets or achieve a larger scale of operations.
The private equity market
A manager, or general partner, is the intermediary between investors with capital and businesses seeking capital to grow.

General partners tend to specialize in companies:

  • within an industry or economic sector, such as manufacturing, business services, life sciences, telecommunications, technology or natural resources;
  • at different stages of development, such as start-ups or early-stage businesses, as well as established companies looking for expansion capital, or mature companies interested in a change of ownership through management buyouts and acquisitions;
  • according to their size in terms of capitalization, and
  • by geographic region, such as Canada, the United States, Europe or Asia.
Performance-based compensation
Compensation to the general partner is paid in the form of a profit participation, referred to as carried interest, usually ranging from 20 to 25% of profits realized when the underlying companies are sold. The general partner usually draws an annual advance of between 1.5 and 2.0% of committed capital as management fees used to select and provide ongoing management support to the underlying companies.
The carried interest is paid to the general partner after a minimum rate of return to the limited partners is achieved.
Earning acceptable returns takes time
Investing in private equity funds can produce low or negative returns in the early years. The rewards usually come several years later as the investments mature. This timing is known as the J curve effect.
Example of a J curve
J curve graph

In the initial years, investment returns to the limited partners are negative because the general partner's management fees are drawn from invested capital, accounting and valuation policies tend to result in portfolio writedowns occurring more quickly than increases in carrying value, and because lower performing investments are identified early relative to the better peforming investments which are often held longer and sold later in the life of a fund. Over time, the progress made by investee companies justifies a value for the business that is higher than its original cost, resulting in unrealized gains. During the remaining period, the higher value of the businesses is confirmed by the partial or complete sale of companies, resulting in cash flows and realized capital gains to the partners. Private equity investing may involve a series of J curves because capital is invested in different investment funds and private companies at different times.
Valuation and performance measurement
In the early years of a private equity fund, valuations of portfolio companies are utilized to measure the performance of the portfolio. Private market investments are carried at cost for at least the first year of ownership. The sale of portfolio companies, or public offerings of their shares, results in cash and occasionally share distributions to the limited partners.
The most widely used measure of performance is the internal rate of return (IRR). The calculation of the IRR takes into consideration the timing of cash distributions to the partners (realized IRR), or the length of time an investment has been held (unrealized IRR), relative to when capital was drawn down to make each investment.

Another widely accepted measure of performance is multiple of capital contributed (MOC) or a multiple of distributions received relative to the capital invested. This measures the proceeds received when an investment is sold, or the valuation of an investment still held, as a multiple of the original cost of the investment. ROC does not take into account the length of time between the date the investment was made and the valuation date (unrealized MOC), or the date the company was sold (realized MOC).

 

Source: CPP Investment Board

 
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