For all of you savvy investors who are bristling already with thoughts along the line of “Indexes don’t apply to case based investing” and I don’t trust the stock market, that’s exactly why I am considering placing my trust in private equity investments,” please bear with me for a few minutes. Let’s start with a little background on the stock market and the creation of indexes. Venice, Brussels, Amsterdam, and London all hold their own rightful claim for the creation of the stock exchange as we know it today, and it is generally accepted that trading has been around at least since the 1400’s. In the early years, this exchange looked an awful lot like the private equity markets of today. Regulation didn’t begin to take any serious hold until the South Sea Company bubble burst in 1720. Presently, the global stock exchange is a heavily regulated marketplace generally deemed as close to a “perfect” market as the world has ever experienced. The major indexes provide a high-level glimpse into the trends, performance, and sentiments of major segments of the global economy as a whole. For centuries, the stock exchange was where investors put their money to work, and where businesses raised capital. With the preponderance of take-private transactions and the proliferation of private equity mega funds, it is pertinent to consider that the tides are shifting in the investment field of play.
current talk of the “everything” bubble gives even the most bullish investor sufficient justification to proceed with caution
There are many reasons why investor sentiment is shifting. The memory of the dot-com and housing bubbles linger as fresh wounds in the hearts and minds of seasoned investors, and current talk of the “everything” bubble gives even the most bullish investor sufficient justification to proceed with caution. Private equity investments are illiquid, which can provide some buffering from the volatility of the stock exchange (Bernstein, Lerner, & Mezzanotti, 2019) There is also an increased degree of access and control with private equity investments. There are often fewer limited partners in a fund than shareholders in a public company, increasing the impact and influence each investor can exercise over investment and growth strategies. In times of tightening credit, investors in private equity structures are able to relax capital constraints whereas public companies are more likely to experience a sell-off of stocks which will exacerbate similar financial constraints.
~ $1B – Average Fund Size
> $700B – Closed Transaction Value
> 4,500 – Total PE Transactions Closed
There has been a major surge in private equity activity, both in the raising of larger and larger funds and in the number of new firms and family offices. In 2018, the average fund size was nearly $1B, more than $700B in transaction value closed, and more than 4,500 transactions took place in the private equity marketplace (PitchBook, 2019). Current trends both in private equity growth and in take-private transactions suggest that transaction value will top $1T in 2020 (Bain & Company, 2019). With this growing swath of global businesses backed in whole or in part by private equity and the precipitous decline in publicly listed corporations it becomes apparent that private equity markets are playing an increasingly significant role in global economies.
All of the growth in fund size has dramatically changed the landscape of the private equity transactions. In the old growth lifecycle of businesses, private equity held a niche space providing an exit option for owners and preparing them for an IPO. This is no longer the case as billion-dollar funds are paving the way for mega-deals and providing an enticing alternative to the IPO (Intralinks, 2019). It is also important to note that private equity backed companies are outperforming their industry peers (Bernstein, Lerner, Sorensen, & Stromberg, 2010) both public and private, so they have a disproportionately significant impact on economic growth and recession buffering. Private equity backed companies tend to be nimbler and more entrepreneurial than their public counterparts, while being more sophisticated and robust than closely held peers. Another advantage to investors is the greater control they enjoy in how their capital is invested and how the organizations are managed. Furthermore, business valuations in private equity transactions at the top end of the middle market are beating public valuations further enticing investors to move their assets out of the public markets to capitalize on these upsides.
Once the economic impact and scale are recognized, the pieces begin to fall into place for my initial premise. Private equity assets under management (AUM) crashed through the $5T mark in 2017 and show no signs of looking back. Consider for a moment that the global GDP for 2019 is $87T meaning that private equity AUM is approaching 10% of the global GDP, and investments are heavily concentrated within the G7 countries (GDP $40T) meaning that there is a concentration of economic impact. If we accept that a significant and growing volume of investment capital is shifting from public markets to private equity markets, that businesses backed by private equity perform differently than their public and closely held counterparts, and that private equity backed businesses account for a significant portion of the global economy, the argument for indexing performance becomes relatively straightforward.
Bain & Company. (2019). Global private equity report 2019. Retrieved from https://www.bain.com/contentassets/875a49e26e9c4775942ec5b86084df0a/bain_report_private_equity_report_2019.pdf
Bernstein, S., Lerner, J., & Mezzanotti, F. (2019). Private equity and financial fragility during the crisis. The Review of Financial Studies, 32(4), 1309-1373. http://dx.doi.org/10.3386/w23626
Bernstein, S., Lerner, J., Sorensen, M., & Stromberg, P. (2010, January). Private equity and industry performance. Management Science, 63(4), 1198-1213. http://dx.doi.org/10.3386/w15632
Intralinks. (2019). Intralinks Deal Flow Predictor. Retrieved from https://www.intralinks.com/insights
PitchBook. (2019). US PE Breakdown: 2018 Annual. Retrieved from www.pitchbook.com