While private equity has historically been available primarily to institutional and high-net-worth investors, the market has been undergoing a significant transformation. The recent emergence of tender offer funds, under the Investment Act of 1940 (“40 Act”), provides individual investors with greater access to private equity as well as other alternative investments. Lower investment minimums, simplified tax reporting and potential for liquidity are just some of the key features.
Investing in an “evergreen” tender offer fund eliminates the need for continuous capital contributions, meaning investors can stay invested in the market and not worry about cash flow management. Investors deploy their entire investment up front in an initial subscription versus periodic capital calls during the life of a traditional private equity fund. Distributions are automatically reinvested – unless requested otherwise – so that investors benefit from the effects of automatic compounding.
Private equity tender offer funds may appeal to a variety of investors, including:
- Individual investors seeking access to private equity for the first time
- High-net-worth individuals looking for a simplified structure and improved liquidity
- Institutional investors leveraging the fund as a portfolio construction tool, enabling them to add private equity exposure while benefiting from a simplified structure and potential for improved cash flow management
Building a diversified private equity portfolio
Constructing a diversified private equity portfolio requires knowledge of and access to a broad array of private equity investment opportunities – across strategies, geographies, industries and vintage years –available through three main types of investments:
- Primary investments are investments in private equity funds managed by general partners (GPs), providing diversified exposure to various sectors through multiple underlying portfolio companies.
- Co-investments provide exposure to a single portfolio company alongside a GP, who typically offers co-investment opportunities to current and prospective limited partners (LPs).
- Secondary investments represent acquiring existing interests in a private equity fund, whereby sellers obtain liquidity through the secondary market and buyers achieve diversification through investing in a more mature portfolio of identified assets.
Investment selection is key
Investment selection is the most crucial element for achieving return enhancement through private equity. As illustrated below, private markets exhibit wide dispersion of returns. Due to this dispersion, proactive sourcing, active management, and portfolio implementation are as important (or more important) than the decision of how much to allocate to private equity.
In the quest to generate attractive private equity returns, relationships and sources of deal flow are more critical than in the public markets, as there are no perfect sources of information about private companies or private equity opportunities.
Due diligence is critical
The importance of an in-depth due diligence process cannot be overstated. In order to meet the objective of return enhancement, it is critical that a private equity investor invest with the highest quality firms on a consistent basis. Unless the requisite skills and resources are available in-house, this means joining forces with a manager that has longstanding relationships with top-performing GPs, a due diligence process to identify high-conviction opportunities and a selective and disciplined approach to investing. Longstanding networks, existing portfolio data and, in some cases, existing board seats can strengthen relationships with the most talented GPs, thereby fostering deeper understanding, transparency and dialogue. This approach creates a virtuous cycle whereby GPs view the manager as a strategic partner and look for additional ways to work together.
Experienced private equity managers apply partnership- and company-level due diligence across strategies and geographies to evaluate both individual company investments and the embedded portfolios of funds and companies in the secondary market. These skills include analysis of a GP’s track record and capabilities as well as a company’s market, operations, labor resources, facilities, equipment and asset base, customers, capital structure and sources/uses of proceeds.
Understanding market segments
Additionally, an experienced private equity manager needs to understand the entire spectrum of companies comprising the private equity market, from the largest to the smallest companies. For example, in the J.P. Morgan Private Equity Group (PEG), we focus on small and mid-market companies, which represent a broad opportunity set with attractive risk/return potential.
The exhibit below shows that the small and mid-sized buyouts occupy the “sweet spot” in the private equity ecosystem. They represent the largest addressable market with the lowest entry valuations and have exhibited more attractive performance in comparison to their large-market counterparts.
Because performance dispersion is wider at the smaller end of the market, manager and asset selection are crucial to capturing value. This underscores the importance of working with a manager like PEG who employs a time-tested diligence process implemented by a team with decades of experience investing in small and mid-market private equity opportunities.
A thoughtfully constructed portfolio that is diversified across managers, styles and geographies is critical to successfully investing in private equity. As more “evergreen” tender offer funds become available and the private equity investor base widens, it is important to recognize that private equity remains a long-term investment. Accordingly, both investors and their financial advisors need to possess a thorough understanding of this asset class.
Democratized access to private equity means improving transparency, upgrading client-facing infrastructure and increasing investor education – trends that have the potential to shift the industry as a whole.