The Untapped Private Equity Opportunity

Private equity investing has steadily emerged as a significant component of the modern investment portfolio. Once confined to a lonely corner of the investment spectrum, it has developed into a major asset class over the past two decades. According to a survey conducted by Blackrock, global capital allocators hold about a quarter of their portfolios in private assets, out of that 60% is estimated to be in private equity, based on a study done by McKinsey & Co.

However, investors are still understanding the great untapped potential that still exists by investing in private companies. Indeed, as reported by Hamilton Lane, 87% of US companies with over $100m in revenue are privately owned and 60% of ‘unicorns’ (venture companies valued over $1bn) reach their potential before they go public.

For Shariah-compliant investors searching for growth, private equity markets offer an attractive opportunity, particularly whilst other options for investment remain limited. But accessing this asset class can be a challenge for individual investors.

In today’s volatile markets, the allure of private equity investing lies not only in its potential to deliver substantial returns, but also in its ability to provide much needed diversification. As traditional asset classes face increasing uncertainties, private equity’s ability to generate higher returns becomes all the more enticing.

Understanding Private Equity

Private equity investing involves investing in private companies and supporting them with the aim of driving up their value before, ideally, their sale for a profit. For individual investors, the best way to access private equity is through funds, led by specialized fund managers with proven records of success.

But the selection of the right fund manager in private equity is crucial – a significant disparity exists in returns generated among managers, much more so than between those in public markets. As highlighted in the graph below from Cambridge Associates LLC, top rated managers have average returns of over 30%, with median returns of around 10%. Note however, that this median is still higher than several actively managed long-only strategies.

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Core strategies for Shariah-compliant investors

Whilst multiple forms of private equity strategies exist, venture and growth strategies are more suitable for Shariah-compliant investors. This is because to be more aligned with Shariah principles for investing, these funds are much more focused on driving value from business growth, as opposed to buyout-funds that utilize debt to enhance return on investment.

There are three key structures to consider within these funds:

1.      Primary Funds

At the time of offering, investors commit to invest in a private equity fund, believing in its manager and strategy. The fund manager then calls capital from the investors, often at intervals and deploys it across various portfolio companies.

2.      Secondary Funds

This is often done through specialized secondaries fund managers, who acquire companies previously owned by other primary funds. It can be done by either acquiring a stake in an existing primary fund, or by acquiring specific companies from a primary fund. In both instances, the primary fund manager maintains control over the investment and continues supporting its growth. This can be an attractive option for investors looking for higher opportunistic returns and greater diversification.

3.      Co-Investment Funds

This involves investors participating in minority stake acquisitions alongside other private equity funds. This can be done directly through dedicated investment structures or though specialized fund managers.

There are two key advantages of the co-investment structure:

1.      Lower fees: Investors have direct access to the fund manager’s expertise in managing or directing the company, but without investing directly into their fund and so not having to pay them full fees.

2.      Shorter Duration: The ability to allocate capital to investments led by different fund managers provides the flexibility to invest and liquidate investments faster.

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The Key Benefits of Private Equity

Less portfolio volatility and risk diversification: By investing in private equity, often across varied industries and stages not present in publicly traded markets, investors can diversify their portfolio holdings, potentially lowering its risks. This is particularly important for the Shariah-complaint investor, given a more limited spectrum of investment options are available to them. Private equity portfolio valuations also tend to show less volatility than in public markets.

The chart below highlights the reduced levels of portfolio risk, along with higher returns, the more private equity forms part of an investor’s portfolio. The data incorporates findings over 25 years to 2018.

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Higher returns: We discuss this more at length below, but it is clear that private equity has historically generated higher returns compared to traditional asset classes – regardless of the time horizons expected in private equity investing. Top-ranked private equity funds have been able to achieve an average of 20% return and double their investor’s capital over various time periods.

Stronger performance control: Investing in private equity often allows fund managers to have a level of control that other investment types do not offer. Depending on the strategy, investors can actively participate in investment decisions and become actively involved in a company’s decision-making process.

In line with long term goals: Investing in private equity is a long-term strategy, often with a minimum 10-year horizon. With this comes the prospect of higher returns, as stated above. But it also makes them suitable for retirement planning and generational wealth transfer.  

Private Equity’s Challenges

Huge sums required for investment: The need for very deep pockets (often in millions of dollars) is needed to make a direct investment into a top performing fund. This is why global private equity platforms, such as Mnaara, are hugely important.

Limited access: For the ordinary investor, accessing top-quartile funds is tough given that long-term relationships are often crucial in this space. Add the limiting factor of such funds possibly being not Shariah-compliant makes it even more difficult.

Longer investment horizon means less liquidity: With a longer investment horizon before value is realized, private equity is deemed an illiquid asset class. Capital is called by the fund manager during the ‘Investment period’ and investors cannot ‘cash-out’ when they want in the earlier stages. However, private equity investors have tended to be compensated with an ‘illiquidity premium’ – effectively an excess return for their capital being tied up for longer.

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Expectations of Much Higher Returns

As highlighted above, higher returns are a primary benefit of investing in private equity. Given that funds tend to invest in companies with major growth potential, investors expect a higher level of return than that generated in public markets.

Whether performance is measured across 5 years, 10 years or even 20 years and across geographies, private market equity investments have historically strongly outperformed public equities.

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However, it should be noted that the level of return can vary widely between top-quartile and bottom quartile funds. While top ranked private equity funds have shown to have at least doubled their investment value over historic periods, bottom quartile funds have barely broken even since 2010. For this reason, investors should always be mindful to invest in funds, or platforms, that target mid to top-quartile performers.

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Private Equity Investing is Getting Increasingly Favourable

The past year has not offered much by way of positive news flow for markets in general. Volatile stock markets have been driven by Russia’s invasion of Ukraine, supply chain disruptions, sharply higher oil prices, a hike in inflation and interest rates… the list goes on.

But with such challenges come opportunities. Yes, risks still remain. For example, high interest rates continue to endure, so liquidity problems still exist and uncertainty in global events mean markets remain volatile.

However, as markets correct, valuations become more attractive. This is good news for new funds or those making additional investments right now. Opportunities to realize significant relative returns over a longer time horizon are increasingly becoming evident.

Furthermore, the strategic advantage of taking a longer-term perspective aligns well with Shariah-compliant principles.

As is so often said, timing is everything in investing. Right now, notwithstanding the benefits mentioned above, we see private equity as a viable diversifier for investors and an opportunity to make significant returns, given that investments have historically tended to fare better post a market downturn (see the chart below from Bain & Company - Global Private Equity Report 2023). This is important in forming part of an investment strategy – and especially so for the investor that adheres to Shariah principles.

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Author

Saad Adada, CFA