By: Dave Kelly, Head of Gluskin Sheff, Onex’ wealth management platform
As any investor can attest, finding robust long-term returns is easier said than done, particularly in times of elevated market volatility. Adding to this challenge is that individual investors may not traditionally have had access to many of the more lucrative alternative investing strategies long favoured by institutional investors such as large banks and pension funds.
Fortunately, this dynamic has begun to change, most recently in private equity. The private investment space has been opening up to U.S. investors over the last few years, but this process has been slower in Canada. However, entry points into private equity are now becoming available for Canadian high-net-worth investors, providing a compelling opportunity to participate in an investment class known for both favourable returns and capital preservation.
From the outside, private equity may seem like a black box, with little information flow compared with public markets. In essence, private equity firms buy significant ownership stakes in businesses with the intention of compounding value according to a business plan and returning cash once investment growth rates slow, sometimes up to a decade or more later.
But unlike an ownership stake purchased on the stock market, private equity investments typically involve purchases of privately-held companies or the purchase of a publicly-held company in order to take it private. It’s a form of investment that requires exhaustive research on the part of the private equity firm, as well as deep industry knowledge coupled with a plan to increase value, significant capital, and the patience to hold investments for several years before realizing a gain.
Because of this, private equity investing isn’t quite as simple as investing in a typical mutual fund. There are minimum investment levels that need to be met and the fees are higher, as this type of investing requires considerable work on the part of the PE firm to research and structure deals.
Adding a private equity component to a portfolio allows accredited investors to participate in a segment that historically has exhibited higher returns than are available in most public market funds. This is because of the multiple levers PE firms have to generate growth from their investments.
Investing in early-stage private companies, for instance, allows investors to participate in a period of growth that tends to be much more rapid than that of more mature companies. Private equity firms are also often able to influence the strategy and direction of their portfolio companies through their significant ownership stakes. They can use their experience to help accelerate growth and transform companies into more appealing acquisition targets.
Through their ability to obtain and prudently manage debt to finance company purchases, private equity firms can also further expand equity return rates for investors.
As a result, private equity funds tend to target higher long-term returns compared to those of a typical public equity fund. Private equity may also offer a return profile that is generally not correlated to public securities, an aspect that is particularly appealing in the current climate of turbulent financial markets.
The increased access to private equity comes as many companies are staying private for longer periods than in the past, delaying their entry to public markets. This has led to a balloon in demand for private funding and means that the typically faster-pace growth that companies experience in their early years is increasingly staying in the private sphere.
However, there are rules and risks specific to private equity investing that investors need to take into account. Perhaps the most significant risk is that investors usually must commit to an investment holding period of several years, often a decade or more. This is so the manager can find the best opportunities, acquire the stakes, build value, and then find an appropriate time to exit the investments, ideally after substantial appreciation. This is not a risk familiar to public market investors who are used to being able to sell a position in a matter of hours or days.
Because of the long hold times, private equity is only appropriate for investors who will not need access to the funds for several years. There are minimum standards for investible assets that prospective investors must meet. As I noted earlier, there is also a higher fee structure than a traditional mutual fund to reflect the more hands-on approach taken by the manager.
If you’re thinking this is a complicated space in which to operate, you’re right. It’s also one that has grown significantly since private equity firm Onex Corp—Gluskin Sheff’s parent company—was founded in 1984. For Canadian accredited retail investors, this is still a new frontier, and the access points are limited. Key to success is finding a private equity fund manager with experience and a proven track record in private equity, as well as a policy of committing their own funds to the investment pool so that interests are aligned.
Ultimately, investors should weigh the pros and cons of incorporating private equity into their portfolios. With the right private equity firm, one that understands how to construct and run a private equity fund, there is now potential for individual investors to realize institutional-level returns, while also participating in the growth of the next generation of great companies.