How to recreate private equity in your portfolio

The short version

• Private equity is usually used by institutions and accredited investors to invest in private businesses.
• The value of private equity has boomed in recent years and on average, they tend to outperform the S&P 500 by 1% to 5%.
• While retail investors don't generally invest in private equity, there are ways to get exposure to private companies, such as through SPACs, BDCs, and more.

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How does private equity work?

Before we dive into the juicy opportunities available to you, we should fully explain what private equity is.

Private equity are private funds, which generally raise money for institutions and accredited investors, and then lock up that money for a number of years. This means investors have no liquidity for that investment until the lock up expires.

With the money raised, fund managers aim to take over a private business with the goal of increasing its value in a short amount of time, in order to be acquired or IPO at a significantly higher valuation. Alternatively, they can target a public company to take it private and do the same.

In order to maximize the returns on a fund over its given lifetime, a private equity (PE) fund will often use leverage (loans, often with the target company’s assets as collateral) to pursue multiple deals. Fund managers also maximize returns by selling their target businesses for a profit in a short amount of time, in order to reinvest those profits into more deals.

These funds generally have an expiry date, in which cash plus profits are returned to investors. If successful, many private equity managers will launch a follow-on fund immediately after or even during.

More: How private equity works

A short history of private equity

Private equity came to prominence during the '80s, specifically utilizing leveraged buyouts (LBOs). During this period, companies would acquire a business, often in a hostile takeover, by issuing massive amounts of debt and pledging the target business’s assets as collateral. After the takeover was complete, the target business would often be saddled with a significant debt burden. In order to generate as much profit as possible, many of these companies would then look to aggressively cut costs and sell pieces of the business that they had just acquired.

Through these often hostile acquisitions, the LBO gained a negative reputation — as did the companies that pursued them. Most saw those companies as predatory actors looking to siphon a healthy business’ cash to enrich themselves.

The LBO bonanza was reigned in eventually as investment banks and law firms figured out effective ways of countering these takeover attempts. From the ashes of this once aggressive and immoral practice arose a new generation of private equity funds, which worked with their target company to increase shareholder value and, by extension, the value of their PE funds.

Today, the private equity industry has matured and ballooned in size. By the end of 2019, global assets under management in the private equity space was estimated at $4.5 trillion and private equity managers were referred to as “masters of the universe.”

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Private equity as an asset class

Today, private equity is a cornerstone asset class for large institutional investors due to the equity-like returns they provide, with less volatility than the public markets. This is partially due to the fact that private equity operates within private companies and are thus shielded from the daily (and often irrational) tides in the market.

Research has shown that on average the private equity market tends to outperform the S&P 500 Index in excess of 1% to 5%.

It is unsurprising that institutions flock to these funds. If ever there was a barometer for savvy institutional investors to track, it would have to be university endowment funds. These funds have relatively broad mandates and are able to invest in a variety of assets in order to grow their university’s nest egg. On average, these endowments invest a huge allocation to private equity and a comparatively minor allocation to U.S. equities.

The results speak for themselves: Yale’s endowment, when headed by Larry Swedroe (who established the endowment approach of increased allocation to non-equity asset classes for equity-like returns), generated an average net return of 16.1% per annum between 1985 and 2005.

Note that private equity is a hugely varied market and can also include private investments in infrastructure, or private investments in startups and private growth companies (also known as venture capital). All of these are different ways to achieve the same goal: equity-like returns with lower correlation to the broader market.

How retail investors can recreate private equity

For the longest time, retail investors had no access to private equity funds. That, however, is changing. In fact, there has probably never been a better time for retail investors to gain exposure to alternative assets.

Some of the strategies outlined below have been around for some time, while others are brand new. Each has its benefits and downsides, and the plusses are highly dependent on an investor’s individual needs, so do your research or talk to a financial advisor first.

More: How to choose an online financial advisor

SPACs

SPACs (or special purpose acquisition companies) are, in layman's terms, a shell company that holds cash. Its only goal is to find a suitable acquisition target and to merge with it. Investors in the shell company get a ground floor interest in a brand new, exciting public company while the target company gets an easy way to skip past the burdensome IPO process and get the influx of cash needed from a public equity raise. Finally, the SPAC manager often gets commissions from both sides of the transaction.

These SPACs, before merging, are publicly listed and allow anyone to invest in them. That means for the first time, retail investors are able to invest in a company going public on identical terms as institutions. Generally in an IPO, blocks of shares are earmarked for institutional investors at agreed-upon prices. When a hotly anticipated IPO goes public, shares can double or even triple — meaning retail investors can only buy at highly inflated prices, while institutions have already locked in a profit

Although today SPACs are mainly known for bringing high-growth tech companies to public markets, they are often looked at as an easy way to gain VC-like exposure to late-stage startups. There is certainly an element of that, though established companies such as Burger King went public in 2012 through the SPAC process. There are ways for retail to also get in on private equity deals through SPACs.

The sheer supply of SPACs since the pandemic has somewhat diluted the quality of the underlying deal and the acquisition target, so doing your own due diligence is key here.

ETFs

ETFs (or exchange-traded funds) are the mutual funds' hipper, more modern little brother. Trading on stock exchanges just like stocks, they provide investors with ample liquidity and low management fees. There are passive ETFs that track just about every index imaginable and, yes, there is a private equity index too.

There are indexes that put together the largest publicly traded private equity companies (more on that in a second), in order to average out their returns as a group. These ETFs simply follow that index and track the group’s returns. Each ETF tracks its own index and some, like the Invesco Global Listed Private Equity Portfolio, track a global group of private equity firms. Others, such as the ProShares Global Listed Private Equity ETF, track a more concentrated, U.S.-centric index of 30 or so private equity firms.

The upside here is that as a retail investor, you may not know anything about private equity other than what you’ve read in this article — you don’t even know who the main players are! These indexes cover all the headaches of researching and deciding between individual firms or SPAC deals. The private equity ETF is probably the most hassle-free way to get the benefits of private equity as an asset class in your portfolio.

The downside is that private equity returns are often not evenly distributed. A single firm or two may capture most of the gains in the industry in a given year. This leads to a scenario where a couple individual stocks skyrocket, while the rest of the group lag or even decline, lowering your average return. In essence this is the price you pay for diversification, but we will look at this issue more closely below.

We should give an honorable mention to some infrastructure-based ETFs as well. Many private equity firms focus exclusively on infrastructure such as gas pipelines, and these firms are often not listed on any index. While this sector may not provide the same mouthwatering returns, there is a much lower correlation to the broader market as well as an emphasis on dividend payments over growth.

Individual stocks

Many who read all the attention-grabbing headlines related to the largest private equity transactions forget that many of the biggest names in the industry trade publicly and anyone can invest in them. Some of these public companies include legendary names such as Apollo, Blackstone and KKR. The same goes with some major venture capital firms such as Softbank.

When you buy these shares, you acquire an ownership stake in their overall business rather than individual transactions. This means you get to benefit from the cash flows the company generates (in the form of dividends and share price growth), as well as the high quality management leading these firms.

There are, of course, obvious differences to investing in the company’s stock or their actual fund as an institution. These funds are often highly-leveraged and promise the possibility of multiples on your investment. Of course these funds can also blow up, leaving your money locked up. While with the underlying stock, you are free to sell whenever you feel like.

The major downside is that individual private equity companies can be very volatile in the short term. The slightest issue in one of their many deals can send shares tumbling, while a major new deal signing can send them soaring. This means that the individual names as an investment act as the opposite of the ETF route: much more volatile, with the chance for more gains.

BDCs

BDCs (or business development companies) are relatively unknown to the average investor and may represent an untapped market.

These companies are listed on public exchanges and deal in exclusively lending out money or even buying stakes in small and medium businesses (SMBs). This corporate structure was created by the U.S. Congress in the 1980s in order to incentivize funding for the growing SMB sector — an industry that traditional banks were still cautious to lend to.

As long as they invest at least 70% of their assets in SMBs and dispense 90% of their profits to shareholders in dividends, BDCs benefit by not having to pay corporate income tax on the profits they give out. This leads to most BDCs having very high dividend yields, giving investors who are also looking for cashflow an ideal solution.

If they sound similar to PE and VC funds that's because, well, they are. Both groups look to invest, lend to and advise private businesses, and in the case of PE and BDCs, rely on debt. BDCs, however, are liquid, highly regulated and any investor can invest in them. Additionally, many BDCs focus on lending and advising rather than taking equity stakes in their portfolio companies.

Because BDCs have that loan element, there is more safety compared to a leveraged buyout. If things turn south, debtholders always have more rights than shareholders. Their profits are also paid out in dividends which help smooth out any volatility in their share prices.

It's not all perfect. Because these companies can’t reinvest profits and must pay dividends, their growth may be slower compared to some private equity companies. If they are growing, oftentimes it will be due to an increase in leverage. Finally, even though lending money can be safer than buying equity, SMBs are still incredibly sensitive to the business cycle so be prepared for volatility during a bear market.

Can retail investors replicate private equity?

In the same way as institutions? No. All of the alternatives mentioned rely on publicly traded stocks. One of the biggest benefits of the private equity asset class is that the investments are private. This opacity lends itself to all manner of benefits.

That being said, the above options could get you relatively close to having that exposure and, in some cases, may have even given some brand new ideas for your stock selection.

If your goal as a long-term investor was to get exposure to private equity as an asset class rather than looking for a get rich quick scheme — you may want to look into an allocation to a private equity ETF or a leading publicly-traded private equity firm.