Capital fundis an attractive investment option for high-value individuals and institutional investors due to the potential for high returns. Private equity falls under the category of alternative investment categories.
Although the definition is confused, private equity usually refers to a managed pool of funds raised or borrowed. These funds are used explicitly to acquire an interest in smaller companies with growth potential. Private equity firms encourage investment from rich sources by being biggerreturn on investment(ROI) than other alternative asset classes or more conventional investment options.
Key learning points
- Private equity produced an average annual return of 10.48% over the twenty-year period ending June 30, 2020.
- Between 2000 and 2020, private equity outperformed the Russell 2000, S&P 500 and venture capital.
- However, compared to other time frames, private equity returns can be less impressive.
- A high degree of risk tolerance and the ability to handle significant illiquidity are necessary for success in the private equity markets.
Historical returns of asset classes
US. Cambridge Associates' Private Equity Index shows that private equity delivered an average annual return of 10.48% over the twenty-year period ending June 30, 2020.In the same time frame willRussell 2000-index, a performance measure for small businesses, averaged 6.69% per year, while the S&P 500 returned 5.91%.
It is clear that an investor who took a risk with private equity would have achieved a much higher return than those who had chosen the more conventional route: investing in a private equity company.ETFa popular index followed. Furthermore, the Cambridge Associates US Venture Capital Index averaged just 5.06% per year between 2000 and 2020.
Whencompared to other time framesHowever, private equity returns can be less impressive. For example, venture capital performed best between 2010 and 2020 with an average annual return of 15.15%.Additionally, the S&P 500 slightly outperformed private equity, returning 13.99% per year compared to 13.77% for private equity in the ten years ended June 30, 2020.On the other hand, that was still better than the Russell 2000's 10.50% average annual return at the time.
Differences in valuation of public and private equity
Although it is generally easy to determine the price and performance ofstock market listed companyand foundations, private equity and venture capital pose additional problems. In public companies you can simply observemarket pricesand measure price changes to obtain historical returns.
There are a number of different methods for thisvaluation of private companies. An entrance iscomparable business analysis, but it only works if there are public companies that are similar to the private company in question. It is also possible to calculatebook valuefrom private companies like thembalanceris available.
The best estimates of private company valuations are typically made by private equity firms. First, they need accurate estimates to know how much to pay when investing in private companies. Post-purchase, private equity firms also need a steady stream of reliable data, such as balance sheets, for decision-making and information to their investors.
The biggest problem with using valuation measures, such as book value, for comparisonrendement op private equitywith public shares is that they behave very differently from market prices. For example, book value is much less subject to short-term fluctuations in market prices. You would therefore expect private equity to perform worse than public equity during this periodbull marketsand outperform in bear markets. You could argue that this is somewhat artificial. It may be more accurate to compare private equity performance with the change in the book value of publicly traded companies rather than with their market prices. However, these differences tend to balance out in the long run.
Comparisons of public and private equity returns tend to be more accurate over longer time frames.
Disadvantages of private equity
While private equity can be a lucrative investment option for high-net-worth individuals, it is not the only alternative asset class that offers attractive returns. Investors interested in private equity, venture capital or other alternatives should be aware that their potential for higher returns also comes with higher risk. A high degree ofrisk toleranceand the ability to deal with significant mattersilliquidityare necessary for success in the private equity markets. In some cases, selling private equity investments can take a year or more.
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