What is Private Equity?

Private equity can refer to a number of different types of private investments but it usually comprises buyouts, venture capital, and special situations.

Buyouts occur when a private equity fund borrows money (usually using the earnings and/or assets of the target company as collateral) to take a public company private.  The goal of the fund is to unlock value through operational changes, selling off divisions, etc. and then bring the company public again at a higher price.

Venture capital funds provide early stage financing for new businesses in return for large ownership stakes. Venture funds work on the law of large numbers. Since they are working with newer companies it is likely that most will not meet expectations, but the ones that do can reap significant gains. Venture funds seek to sell their stake in the future for more than they paid.

Special situations encompass a number of different investment strategies that don’t exactly fit into buyouts or venture capital.

Why Private Equity?

The two main reasons why private equity makes sense in a portfolio is the opportunity for higher returns and a low correlation to other assets. Markets always reward investors for taking risk. Since private equity funds lock up money for long periods of time, investors usually get an illiquidity premium. According to Venture Economics, private equity has outperformed the stock markets by 4.31%/year:

Venture Capital & Buyout Funds Have Outperformed the Public Markets
Growth of $100 December 1985-December 2004

S&P 500	$517
Nasdaq	$614
Buyouts	$932
Venture Capital	$2,002

Source: Cambridge Associates

Private equity has also historically had a low correlation to public markets:

Correlation Matrix

	Buyouts	Venture Capital	S&P 500	Nasdaq
Buyouts	1	.64	.66	.47
Venture Capital		1	.35	.54
S&P 500			1	.57
Nasdaq				1

Large endowments have successfully used investments in hedge funds and private equity in order to meet their objectives of generating attractive risk/return while growing their endowment for an unlimited time horizon. Family offices and exceptionally wealthy individuals/families can learn a lot from the investment strategies of large endowments and should seriously consider adding hedge funds and private equity to their investment mix.

The Family Office Association would like to thank contributing editor Matt Tuttle.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any investment in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.

This document is not an invitation to subscribe for shares in any fund and is intended for informational purposes only. Hedge funds are speculative investments and are not suitable for all investors, nor do they represent a complete investment program. The funds are only open to qualified investors who are comfortable with the substantial risks associated with investing in hedge funds.