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Private Equity, Private Markets

Private Equity Demystified: Why This Investment Approach Deserves More Attention

Private Equity and Grasshoppers – it's been a long time since the then leader of the Social Democratic Party Franz Müntefering made this comparison in 2005. Since then, Private Equity has repeatedly proven that it not only delivers better average returns than investments in the public capital market but also makes an important contribution to the overall economy's development.

Nevertheless, Private Equity is often still wrongly categorized. While hedge funds were reffered to at that time, today it is often still mainly associated with venture capital. However, both are just sub-sectors of Private Equity or the private market itself.

“A Private Equity company provides companies in need of financing with equity capital or equity-like financing instruments off-exchange,” says the Federal Ministry of Finance website.

Expert Panel Carefully Decides on Investment

And they don’t just do this on a whim: experts from PE companies or asset managers intensively engage with the target company long in advance. Through detailed due diligence, which can last weeks or sometimes months, and strategic discussions with the company as well as market and future analyses, the opportunities and risks are assessed. Based on this, a multi-member and highly experienced investment committee makes the investment decision.

Subsequently, a growth strategy is developed jointly with the company and implemented in the following years. The asset managers often become part of the management team through their participation, thereby not only acting as external advisors but also actively participating in the implementation. Through direct involvement, asset managers also share the entrepreneurial risk with the founders and boards. By joining, they usually bring new resources in the form of money, expertise, and advisory services.

Furthermore, investment companies support expansion and internationalization through their typically large networks. Successful scaling of the business model usually benefits the entire company’s environment, including its original economic region. While investors in Private Equity funds can benefit from smaller value increases during the investment period, the management of the investment company usually has a profound interest in substantial growth, which significantly increases their success-dependent participation. Thus, they have a strong incentive for sustainable growth, which ultimately benefits all involved.

Time for Growth

Private Equity investments are designed for the long term, with Private Equity funds typically set for 10 to 12 years. Generally, a target company should have achieved the necessary growth after 5 to 7 years to sell the shares at a higher price or even bring the entire company to the stock exchange. This long-term strategy generally ensures a better risk-reward ratio with lower investment fluctuations. Unlike sometimes highly quarterly-report-driven publicly listed companies, they can pursue a sustainable growth strategy.

Currently, over 90 percent of the capital market in the German economy still takes place off the stock exchange. For example, the number of non-publicly listed companies with revenues of over 50 million euros and more than 250 employees is about 35 times higher than that of publicly listed companies – the famous “German Mittelstand.”

Positive Effects for Private Investors

Historical data shows that the return expectations of Private Equity funds are higher compared to a global equity portfolio. In a broadly diversified portfolio with other asset classes, Private Equity can increase return opportunities and reduce overall risk. For private investors focusing on diversification, adding Private Equity therefore makes sense.

Due to the low correlation between public and private markets, one can generally say that adding private market funds to private investors’ portfolios increases returns at lower volatility and better Sharpe Ratio.

Previously, it was often “60/40” for a portfolio, i.e., 60 percent equities and 40 percent bonds, but today the tendency is clearly towards “50/30/20” or similar models: 50 percent equities, 30 percent bonds, and 20 percent private capital market, for example in the form of an ELTIF, which can cover various private markets asset classes.

Where There Are Opportunities, There Are Also Risks

Even though Private Equity funds or ELTIFs have many advantages, one should be aware of certain risks before investing. Compared to public markets, Private Equity is less volatile, but in a recession, companies under Private Equity ownership can encounter difficulties. However, they have the advantage of having an active owner who can even provide additional capital if needed.

Another important point is liquidity. Private Equity investments are not as liquid as investments in publicly listed companies. And there’s a reason for this: implementing a value creation strategy and growing a company takes time. And this time must be given to the investment companies or asset managers to achieve the desired return.