“The trouble, in my opinion, with corporate America today, is that everything is thought of in quarters.” – Henry Kravis
Over the past year, we have spent a good amount of time researching different options for our clients in the private equity space. What we have found is that there are a number of different options currently available to accredited investors in a variety of different shapes and sizes (e.g. diversified vs. niche strategies or primary vs. secondary investments, etc.). In today’s post, we will look at private equity from a very high level to explain what it is exactly and why it might be a good addition to a well-diversified portfolio.
Everyone who is reading this post knows an example of a company that is privately held (e.g. Cargill, Dell, or a small local business in your town) and plenty that are publicly traded (Apple, Toyota, Wells Fargo etc.). Fundamentally, the only difference between the two is that publicly traded companies are required to file reports on their business every quarter which makes them much more transparent in their operations than private companies, and ownership in a publicly traded company can be transferred quickly and easily via the purchase or sale of shares on an exchange. Other than those two glaring differences, public and private companies, for all intents and purposes, are the same.
According the US Bureau of Labor Statistics and the World Federation of Exchanges, of all the companies in the US with 500 or more employees, only around 19% of them are publicly traded. That means that the large private companies account for a little over 81% of the market and out-number publicly traded companies by a factor of 4-to-1! All that to say, a savvy private equity manager has much more opportunity to uncover hidden value than a manager of public equities/stocks simply due to the size of the market.
Institutional investors such as large endowment funds have known this for a long-time, which is why the average annual allocation to private equity by endowments is currently around 21% of the portfolio. The Yale Endowment, which has long been considered one of the top endowment funds, has a long history of investing in private equity and clocked in at a 32.5% allocation in 2015 compared to a 3.9% allocation in US publicly traded stocks and a 14.7% allocation to international stocks.
So why all the interest and emphasis on private vs. publicly traded equities? The answer is multi-faceted, but the summary is because it offers better risk adjusted and absolute returns. The reason this is true is because of the illiquidity premium and the decision time horizon.
Let’s unpack the second part first. Managers of a privately held company have an obligation to run the company in the best interests of its shareholders/owners, but they have no obligation to file updates or reports on how the company is doing on a quarter by quarter basis. As such, it is easier for the managers of a privately held company to make decisions that are in the best interests of the company over the long-term. In contrast, managers of publicly traded companies are praised or chastised every quarter when their earnings reports are published. A point Henry Kravis who founded KKR, one of the world’s largest private equity firms, stated in the opening quote.
The other reason private equity has historically outperformed its public counterpart is because of the illiquidity premium. The easiest was to understand this concept is through an example. If we had two seemingly identical investment opportunities with the only difference being that one offered daily liquidity while the other was a private investment with no liquidity, we should choose the one with more liquidity since it gives us more optionality in the future as new information on the investment becomes available. As such, in order for the private investment to make sense, it must offer investors a higher return to compensate for the lack of liquidity. This additional return is what we call the illiquidity premium.
The next logical question is how does a private equity investment offer such a premium over publicly traded stock? Again, the answer is multi-faceted but the number one reason is through something called multiple expansion. Size and liquidity are directly correlated to the multiple on earnings an investor is willing to pay for a company. For example, two companies of the same size may be worth significantly different amounts if one is publicly traded and the other is private. An investor may be willing to pay 15x earnings (e.g. P/E ratio on a stock) for the publicly traded company but only 8x-10x on its privately held counterpart. The same is true of size, where larger companies often times demand a much higher multiple than smaller ones. As such, there is value to be unlocked by the private equity manager who can purchase a portfolio of small, private companies in the same industry with the goal of creating a much larger company that has the ability to IPO on a public stock exchange. Additionally, rolling up companies in this fashion also allows the PE manager to realize some synergies through cost cutting (e.g. only have one back office vs. five, etc.) which increases earnings and leads to a higher valuation.
The table below attempts to illustrate this by showing four examples. In all examples, the company grows its top line revenues by 7% a year. Additionally, in all the scenarios, the company starts with a 15% profit margin and is valued at an 8x multiple on earnings. In the first baseline example the company grows revenues and earnings by the same 7% a year with no multiple expansion. The second scenario assumes that revenue growth and the valuation multiple stay the same, but earnings improve from 15% to 17% due to cost cutting/savings. The third example assumes no margin improvement (e.g. earnings remain at 15%), but the valuation multiple expands from 8x to 10x earnings. Finally, the last example puts it all together and assumes a margin improvement from 15% to 17% along with multiple expansion from 8x to 10x. In this particular example, the return from Scenario 4 more than doubles the baseline return in the first scenario simply from a modest improvement in the earnings’ margin and some multiple expansion.
There is a lot more than can be said about private equity that goes beyond the scope of this post, but some important things to consider is how much risk a private equity manager may be taking in order to generate returns that beat their publicly traded counterparts. The easiest risk to identify is the amount of leverage or debt a private equity fund utilizes in its acquisitions of private companies. But if one can identify different private equity opportunities with risk that is commensurate to publicly traded stocks, then it stands to reason that a portion of one’s publicly traded stock portfolio should be reallocated to private equity investments to reduce risk with the added diversification benefit, take advantage of the larger universe of private equity opportunities, and potentially generate higher returns at the portfolio level.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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