Historically, private equity investments have primarily been accessible to large and sophisticated institutions, endowment funds, family offices, and a limited number of ultra-high- net-worth investors. 

Due to the inherent characteristics of private equity, this group of investors accepted inflexible investment terms, limited access to the invested capital, and a general lack of transparency, in return for exposure to an asset class that (the data clearly shows) has consistently outperformed listed shares – before and after allowing for risk – while providing additional diversification benefits.

Private-equity portfolio allocations have ramped up even further over recent years, with this trend expected to remain an ongoing theme, supported by influences such as near-zero interest rates, elevated valuations in traditional markets and the opportunities presented by emerging markets, innovation and disruption. 

At the same time, long-term return expectations continue to favour private equity relative to listed equities, particularly for the subset of private equity fund managers that have demonstrated a consistent ability to achieve top-quartile returns. 

By enabling access to global private equity investments via securities traded on major stock exchanges, listed private equity addresses certain aspects of global private equity that have previously deterred, or even excluded, some investors. 

Listed private investment is available on ASX through the Pengana Private Equity Trust (ASX: PE1). PE1 is Australia’s only listed portfolio of global private equity investments.
 

Understanding private equity 

PE investing is typically characterised by several factors that, to date, have limited retail investors from being able to access this asset class. Risks include:

1. Large minimum investment amounts make it difficult to gain access, and harder still to achieve diversification. Excess demand for top-performing private equity managers means these funds are also generally oversubscribed.
   
   
2. Long-term illiquidity, whereby PE investments often require a substantial minimum commitment that may be “locked up” or inaccessible for 10 years or more.
   
   
3. Inflexible timing, as PE funds are often closed to investors and may remain uninvested for some time as they await underlying investment opportunities.
   
   
4. Lack of transparency, with PE investors having limited information on target companies and receiving infrequent valuations.
   
   
5. Absence of clear price discovery, meaning transaction pricing in private markets depends substantially on negotiations.
   
   
6. Reduced separation between ownership and control, which elevates the role of manager resources and expertise.

However, two further characteristics are observed:

1. Outperformance of private equity compared to public equity. Conceptually, this follows from PE investors requiring compensation for accepting the complexities and illiquidity of PE. 
   
   
2. Ability for skilled private equity managers to distinguish themselves through superior performance. 
   

Private equity performance 

Looking at returns, the outperformance of private equity versus global listed shares is widely acknowledged (see chart 2 below). 

Less well known is the portfolio-diversification benefit associated with including PE in a traditional portfolio of bonds and equities. 

If a 20% allocation to private equity was made to a traditional portfolio of 60% equities and 40% bonds, thereby creating exposure of 50%/30%/20% (equities, bonds, PE), the new portfolio historically generated increased returns with reduced volatility. This is an important result as higher investment returns are usually accompanied by higher risk.

Where higher returns are accompanied by lower risk, as in the case of private equity, that asset class becomes compelling, in Pengana’s view.

Chart 1 below illustrates the higher returns and lower risk of private equity compared to global equities. Moreover, by displaying the ratio of return to risk, the chart shows the superiority of risk-adjusted PE returns relative to both shares and bonds. 
 

CHART 1: Superior risk-adjusted returns [1]

Source: See footnote 1.

More consistent return comparison

However, comparing the performance of PE to sharemarket index returns could be misleading, due to the uncertain and variable timing of cashflows that characterise private equity investments. 

To create a more valid comparison, one technique is the calculation of a ‘Public Market Equivalent’ (PME) equity return series that replicates private equity cashflows in a sharemarket index.

Using this approach, Chart 2 below shows a performance comparison between PE buyout returns and local market equities. 

Over time horizons from three years to five, 10 and 20 years, PE returns are again superior – in some cases, by a large margin.

CHART 2: SUPERIOR LONG-TERM RETURNS [2]