This article is written as part of a DollarsAndSense Bonds Investing Education Series with Azalea Asset Management.
Private equity remains a difficult asset class to access for many, including people within the finance community. One of the primary reasons for this is because unlike other traditional asset classes, such as stocks, bonds or property, private equity is a lot less accessible to the masses.
We explain what private equity entails, how it works, and the different types of private equity investing methods.
What Is Private Equity?
As its name suggests, private equity is basically “equity” which is held in “private” companies. This is as opposed to the definition of “equity” that most of us are more familiar with, which is typically stocks that are held in publicly-listed companies on the Singapore Exchange (SGX) and other exchanges.
Private equity investing is usually done through a private equity fund (PE fund). The PE fund raises money from institutional investors and high net-worth individuals. The money raised is then pooled together to form a PE fund, and invested on behalf of the investors.
To find good investment opportunities, most PE funds need relevant expertise to source for investments beyond just what is publicly available to everyone. They will then make valuable and strategic investments into privately-held companies with the aim of generating a high return for its investors, by eventually selling the companies to other buyers or to list them in the public markets through an IPO.
Unlike investing in publicly-traded stocks on the exchange, investments made in private equity are much less liquid, with an investment time horizon that could span anywhere from 7 to more than 10 years, depending on the PE fund selected. Unlike stocks, private equity investors cannot simply sell their investment holdings as and when they like.
The idea behind this is that businesses, even good ones, take time to grow. A PE fund that invests into a company needs to give it time to grow before it’s able to earn a good return on its capital.
At the same time, the majority of private equity investors are not looking for immediate short-term gains. Instead, they often focus on receiving a longer-term return that is higher, and uncorrelated, to what the public market is giving. Of course, this is easier said than done.
What Do PE Funds Invest In?
To understand how PE funds generate its returns, we first have to understand how they uncover investment opportunities. Here are some common strategies they typically employ.
# 1 Venture Capital
Venture capital is a type of PE fund which focuses on early-stage start-ups that are deemed to have high growth potential. The idea is to invest early, with the hopes that the start-ups will be able to achieve its growth potential and provide a high future return on a relatively low early investment.
# 2 Growth Capital
Unlike venture capital, which invests into early-stage start-ups, growth capital is a type of private equity where investments are made into older and more stable companies that are looking to expand. This could be into an overseas market that they wish to enter, to develop new products or to fund acquisitions.
# 3 Mezzanine Financing
While venture and growth capital involved investing in the equity of a company, mezzanine financing refers to investment in a company’s debt, with the PE fund sometimes having the option to convert part of such debt into an equity interest in the company if the loan fails to be repaid back in time and in full.
Interest rate for mezzanine financing can be quite high, making it a potentially lucrative for PE funds who invest in the right companies.
# 4 Buy-Out/Leveraged Buy-Out
These are investments made by the PE fund with the intent of acquiring controlling stakes in the company. The idea is that by taking over the company, the PE fund is in a position to be able to find ways to create or unlock value for the company. Methods used could include a change in management, streamlining of processes, introducing strategic partnerships to the company or selling parts of the company.
These takeovers usually involve companies with high valuations and may sometimes be funded through a combination of equity (from the PE fund) and debt, as opposed to just an equity investment. This is known as a leveraged buy-out. To secure the loan, the assets or future cashflows of the company may be put up as collateral. The leverage, when used, also allows the PE fund to earn a higher return on its equity. Of course, this also makes the investment riskier, if the company is unable to service its debt.
# 5 Real Estate
Private equity real estates are PE funds that specialises in acquiring real estate properties. These funds typically invest in real estate assets using a few common strategies which includes the following:
Core: Investments that are made in low-risk properties (typically fully occupied) with predictable cashflow.
Core Plus: Investments that are made in properties which are deemed to be slightly riskier, where some improvements may need to be made in order for such properties to provide better returns.
Value-Add: Investments that are made in properties which require significant improvements in order to earn a higher return for the investors. This could include old properties with very low occupancy rate or properties with management issues. The risk of investing in these properties are higher but the returns could potentially be much higher as well.
To find such opportunities, private equity funds may look for overseas properties or properties in specific sectors to give them the returns they seek.
Fund Of Funds
Fund of funds (FOFs) is another investment strategy where, instead of investing in companies, the fund invests their capital into other PE funds.
By investing in FOFs, investors are able to enjoy a diversified portfolio which comprises PE funds straddling different industries and countries, sometimes with different investment strategies as well. Depending on its scale and size, the resulting portfolio could contain several hundred underlying portfolio companies diversified by sector, vintage, region and manager. This reduces the effort needed for investors to gain the same level of diversification for their own portfolios.
How To Invest In Private Equity
Unless you are a high net worth individual, most PE funds across the world are generally exclusive and inaccessible to retail investors due to the large investment sums required, long holding periods, and lack of access to quality fund managers. There are however, still some ways investors can get exposure to this alternative investment strategy.
For a start, some of the world’s biggest private equity companies are (ironically) publicly traded. These include The Blackstone Group, Apollo Global Management and The Carlyle Group, all of which are traded on U.S. exchanges. By investing into the stocks of these companies, you are indirectly getting exposure to private equity as an asset class.
Closer to home in Singapore, Azalea Asset Management (Azalea), a wholly-owned subsidiary of Temasek Holdings (Private) Limited, has developed and launched a product in order to broaden Singapore investor access to private equity as an asset class.
What Azalea does is that it invests in suitable PE funds to form diversified portfolios, and issues various classes of bonds through an asset-backed security structure that caters to investors with different investment objectives and risk tolerance.
In June 2016, Azalea launched Astrea III, the first publicly-listed private equity bond in Singapore. Astrea III, backed by cashflows from the PE funds that Azalea has invested into, is listed and can be bought and sold on SGX (for accredited investors). Its Class A-1 Bonds give a fixed interest of 3.90% p.a. payable semi-annually.
If you are keen to read up more on how Astrea III is structured, and why the bond enjoys a “A+sf” and “A+ (sf)” by rating agencies Fitch and S&P respectively, we recommend you to read this very comprehensive article written by bondsupermart about Astrea III.