The Challenges and Opportunities in Private Equity: Despite a Greater Awareness of Private Equity in Australia, Most Investors Are Still Relatively Uninformed about This Emerging Asset Class. (Private Equity)

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While the level of capital raising by private equity funds has increased sharply in recent years, Australia has only a developing private equity market compared with the United States and, to a lesser extent, Europe.

However, given the spectacular growth forecasts for Australian managed funds, private equity is an asset class that investors should not ignore.

The potential high return and diversification benefits have driven the average strategic allocation to private equity by superannuation funds in the US to more than 7 per cent. The potential for similar growth exists in Australia and some large superannuation funds have already embarked on strong private equity programs.

Many investors still associate private equity with investing in a software company or an internet related company that will deliver 100 per cent returns every year.

In fact, private equity is a lot more than high technology investments, encompassing any investment in unlisted companies. Start-up or venture capital may be a critical (and glamorous) part of the private equity industry, but it by no means constitutes the whole industry.

If the private equity industry is segmented by the stages of investments, those in more mature companies are more significant than venture capital, even in the home of venture capital, the US.

The major types of private equity investments are:

Venture capital: the provision of capital to start up companies with little operating history or profit. Typically, the revenue base is small or even non existing. This is the riskiest type of investment but can also generate very high returns. Based on historical experience, three or even four venture capital investments out of every ten are partially or completely written down.

Expansion capital: the provision of capital for established but not mature businesses. Typically, those companies are already past their start-up stage, but need an injection of capital for their next phase of growth, often as a precursor to an initial public offering of the company.

Management buyout: The purchase of a business by its existing management team. Usually, the business involved in a management buyout is a more mature one with a steady cash flow.

Historical data on the private equity industry in Australia is difficult to obtain, but evidence from the US, summarised in Table 1, suggests that a substantial premium over the listed equity market can be expected.

Although returns are volatile and highly depend on the time period of the data, over the longer term private equity funds in the US generate a premium of around 4 per cent to 5 per cent over the listed equity market.

The higher historical returns on private equity can be largely attributed to the non-transparent nature of the sector. Compared with the listed equity sector in which a large company is followed by hundreds of analysts worldwide, private equity is built on an inefficient distribution of information. Private equity funds often deliver high returns by using their networks to identify profitable investments that are not available to, or ignored by, the listed market.

Another advantage of private equity is the diversification benefits which it can provide to an investment portfolio. Until a private equity investment is realised its value is appraised by independent valuation, which has two benefits.

Firstly, since private equity investments are not marked to market over a short time interval, its appraised value better reflects the fundamental value of the underlying investment.

Secondly, the appraised value of a private equity investment does not strongly correlate with returns in the listed equity market. However, while the listed market does not drive appraised value, realised returns to private equity investors are affected by events in the listed equity market.

When performance in the listed equity markets is strong, the level of activity in the initial public offering (IPO) market increases and private equity funds find it easier to realise investments in IPOs at more attractive prices. …