How does private equity outperform public equity?
Due to its potential for significant returns, private equity is a popular investment choice among high-net-worth individuals and institutional investors. These private equities are usually not disclosed to the main public investor because the company may be in its early stages or the board members do not wish to share the equity with the public.
Even though public equity may mean more capital invested into the business, research has shown that the private equity market has consistently outperformed public equity. Why is that so?
In this article, we will look at how private equity outperforms public equity.
Historical Returns
According to Cambridge Associates’ U.S. Private Equity Index, throughout the 20 years ending on June 30, 2020, private equity generated average annual returns of 10.48%. That is a far greater return than the S&P 500, which provides a return of 5.91% during that period, and the Russell 2000 Index’s average annual return of 6.69% for small businesses.
The data is taken from theconreviews.com, which shows private equity doing better promises of returns that outperform the market, as well as a lack of correlation with the general market, have attracted investors to this asset class. This seems to be the case at first glance. Private equity was the best-performing asset class in the private markets for the sixth consecutive year in 2021, according to the McKinsey Private Markets Report.
How private equity trumps public equity
There are a few key metrics to look at which clearly show why the private equity market consistently outperforms public equity:
Risk to Reward
According to conventional wisdom, only three to four startups out of ten will entirely fail. The remaining three or four repay the initial investment, and one or two generate significant returns. According to the National Venture Capital Association, between 25% and 30% of venture-backed companies fail.
Investing is understandably risky, however, what makes the private equity market a lot more resilient is that private equity is mainly bought by an accredited investor. These investors could have a net worth of over $1 million, or possess a minimum yearly income of $200,000, or $300,000 if combined with a spouse’s earnings. This level of income ought to continue from one year to the next.
Tentatively, an accredited investor has invested in the market for quite some time, and generally, they are more resilient to market fluctuation. These make them hold long in the market as compared to paper-handed investors who flee at the sign of bad times. Because accredited investors are long the private equity firm, they can make significant gains as compared to the retail investor.
Have a better understanding and are supportive of the business
Some private equity firms provide stock equity/stock compensation to their employees for exceptional talent or their dedication to supporting the business. Companies prefer this method instead of full cash income because they would like employees to remain in the business for at least the given period (a period in which options are able to be sold) where they are able to demonstrate their skill. When everyone works hard for the business, the company is able to grow positively.
Aside from that, private equity businesses usually take a longer time to do research, analyze, and finally have the commitment to invest in businesses. This is to ensure they fully understand the business, believe the business they bought is at a fair price, have huge future potential, and are willing to bet big on the business.
Easier to manage
Private companies do not need as many employees in the business as compared to ones that are in public equity. That’s because a private company is a lot easier to manage when it comes to finances and headcount.
Finances are easier to manage in a private equity business as there are not as many shareholders in the business. This allows the investors in the company to have more opportunities to speak up during a shareholder meeting to discuss the future of the company. Apart from that, the business is able to allocate its funding more smoothly as fewer members are in the party that will need the approval.
Secondly, with a smaller headcount, business is easier to manage, and the bond between colleagues is usually tighter. Even though the scalability of employees may not be as fast, the connections made between employees usually are better, and felt like they are well treated.
Not affected by Sarbanes-Oxley
Sarbanes-Oxley is an act created after the Enron, Tyco, and Worldcom business scandals (CEO were fraudulent that ruined the company and investors’ money) to make sure all publicly held companies and their management teams, holding senior managers, are personally responsible for the accuracy of their companies financial statements. This includes creating lengthy mandates for internal control reporting.
However, since private companies are not affected by this act, this means that there will be less management work involved, which means more capital can be reinvested or shared among shareholders.
Special Considerations
As mentioned, who is eligible to invest in private equity firms? The only people who are given the opportunity to invest in private equity firms are large institutions and accredited investors because they have higher capital and better risk tolerance. These investors and institutions would usually have a say in the business strategy, which makes the company grow greater.
Investors will need to delve a little deeper to understand the returns of the private equity sector for comparison, consulting monthly or quarterly industry data.
