Private equity is an asset class that may be confusing to many investors, but it’s increasingly being viewed as a necessary part of one’s asset allocation. Because of the lack of publicly available information and its reputation as a high-risk asset class, many could benefit from someone who specializes in the space. Tyler Bain, the Managing Director of Primark Capital, and Steve McCourt, the Co-CEO of Meketa, have years of experience in the private equity markets and join the ETF Think Tank to discuss them.
McCourt explains that private equity has been around for about 40 years and has evolved quite a bit during that time. Recently, it’s been elevated to a point of “normalcy” in asset allocations. The benefits of private equity are higher returns, higher risk-adjusted returns, and diversification. The exposures within private equity can be very different from what’s available in publicly traded stocks.
McCourt’s firm focuses on building portfolios of companies that are generating free cash flow and producing EBITDA. In many cases, these aren’t necessarily the startup tech names that can be very speculative. In general, valuations can be lower if you’re focused on cash flows instead of growth. With private equity, you’re usually working with lagging data, so there’s some subjectivity in how companies are valued.
In terms of the current economy, McCourt says that it’s going to be a challenging environment for businesses, private equity or not. The impact so far has been fairly marginal, but private equity companies are typically among the first to cut costs if conditions start worsening. Given that, there hasn’t been a meaningful impact on valuations, but that could still be coming. Transaction volume has come down a lot. When rates move higher, assets are priced lower. It just depends on how far they could fall.
McCourt says that one of the biggest risks in this asset class is execution risk, but they’ve been more or less solved in the past decade. If you get execution wrong, it can be painful. There’s also diversification risk. If you have just a few private names, it can be highly volatile. You have to be diversified across vintage years. Valuations and forward-looking returns differ depending on the year. There’s also liquidity risk. You don’t want to be in a position to sell where it requires you to take a big haircut.
The secondary market has become its own ecosystem. Some investors transact billions of dollars every year. Some will use that to buy at a discount whenever they’re available. Some are looking to sell in order to get portfolio allocations back down to target. McCourt and Bain note that advisors shouldn’t invest in any new asset class until you understand it and you can make your clients feel comfortable with it.
Other takeaways:
- Private equity can be differentiated between “buyouts” and “venture”. Buyouts tend to focus on cash flow positive companies. Venture involves valuing a business that has yet to generate revenue or cash flow.
- Bain notes that Fidelity recommends approximately 8% of a portfolio should be in private equity. At Primark, they usually maintain a 10% position in cash & marketable securities to remain flexible. In his fund, you’ll immediately be diversified across all of these risk factors.
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