Private Equity – Elements 25

Private Equity

This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.

Private Equity

What is it?

Private Equity is a subclass of the Investing Element Equities.

  • Equities are shares in companies.
  • They are the part of the company’s capital that isn’t Debt.
  • They represent partial ownership of the firm, and entitle the holder to a share of future earnings (profits).

Strictly speaking, all company shares are Equities

  • But the term has been hijacked for those shares that are listed on a Stock Exchange, and can therefore be easily traded by the public.

Shares in companies that are not listed are known as Private Equity.

  • The term Venture Capital (VC) is used almost interchangeably, but there are some differences that will be discussed below.

What kind of element is it?

Private Equity is an asset class – a subdivision of financial assets.

  • Strictly, Private Equity is a subdivision of the Equity asset class.

Who needs it?

Private Equity has traditionally been a diversifying asset.

  • It combines good returns with a degree of diversification away from the volatility of Equities.
  • In this respect is has similar characteristics to Property.
  • It is a Diversifying asset (rather than a Risk/Growth or Stability one).

Private Equity came to the attention of private investors via two routes, one positive and one negative.

  1. Private Equity firms – who bought up stodgy companies, cut costs and loaded them up with debt to enhance returns – gave it a bad name.
  2. University endowments (for institutions like Harvard and Yale) – which produced high and stable returns by using Private Equity as part of a well-diversified portfolio – gave it a good name.

So the best practice (though not necessarily mainstream) position would be that any investor with a substantial portfolio (anyone aiming for financial independence) would benefit from a small position (say 5%) in Private Equity.

  • Of course, how much exposure to Risk/Growth assets (and by extension, to Diversifying assets) you are prepared to tolerate will depend on your personal attitude to risk.

It has become clear in recent years that the listed equity pool is shrinking.

  • New firms are coming to market much later in their lifecycle, and at a much larger market capitalisation.
  • This means that the gains from the early growth are not shared with those who invest only in listed equities.

Many would argue that this means that it is even more important to include Private Equity in a diversified portfolio.

What comes before it?

Private Equity is one of the riskier asset classes, so there’s quite a lot that comes before it.

  1. You’ll need a financial plan, an annual budget to be sure that you have spare cash to save, and some financial statements to show where you are on your journey.
  2. Next you need to deal with your debts – you should have no debts other than a mortgage on the property you live in before you start to build up an investment portfolio.
  3. And you need to build up a cash reserve  – six months of expenses is the usual recommendation.
  4. Finally you need to have a plan for where you will live.
    • It’s fine to rent, but not usually the most profitable long-term option in the UK.
    • But if you decide to buy, you need to have a plan for how you will finance this.
    • And you need to be certain that you have spare money on top that can be used for investments.

And when you start investing, your first asset classes are likely to be Growth Assets (usually Equities) and Defensive Assets (like Bonds).

  • Once you have these in place, you can think about Diversifying Assets like Private Equity.

In practical terms, you also need a product to put your Private Equity in.

  • This could be a tax-wrapper like a SIPP or an ISA
  • But it could also be a tax-friendly product like a VCT or EIS / SEIS – more on this later.
  • Private Equity won’t be available in most  workplace pension plans.

What comes after it?

See also:  Workplace Pensions - Elements 15

Other Diversifying Assets, like Hedge Funds, Gold and other Commodities, and FX.

  • Then the late (Decumulation) stage Investing Elements like Drawdown, IHT Portfolios, Wills and Trusts.

What age do you need it from?

For almost your entire investing career:

  • Ideally you will be investing from 25 to 75, or even to age 85.
  • It might take you a few years to get to the stage when you need Diversifying Assets, so let’s say from age 30.

Ignore the recent trend towards “life-styling”.

  • here, the proportion of stocks held in your portfolio is (automatically) decreased as you approach a “big bang” retirement date.
  • this is a leftover from the days of annuities, when it was important that your portfolio didn’t crash just before it was converted into a monthly income.

Annuities are poor value now compared with drawdown, and retirement will last much longer than it used to.

  • So it’s safe to stick with a diversified portfolio (including Private Equity) for the long-run.

What age do you need it until?

You need equities until you decide to switch from your own retirement portfolio into a monthly annuity payment.

  • Given current interest rates and longevity projections, this is unlikely to be before the age of 75.

An alternative scenario would be failing mental faculties which make you no longer feel confident that you can manager your own portfolio.

  • If you have no one who can take over for you (via power of attorney), you might want to move into less volatile assets, or convert into an annuity.

How much does it cost?

Private Equity is not a low-cost asset.

  1. The first thing to consider is the holding cost, or platform cost.
    • VCTs and EIS / SEIS can usually be held as physical (paper) certificates, so there is no holding cost.
    • Where you hold VCTs on a platform, they will be treated like ITs (that is to say, like listed shares, which is what they both are).
    • Use a platform with a capped fee so that additional shares don’t increase your costs.
  2. The second thing to consider is the acquisition cost.
    • With EIS and VCT, you will usually be given newly created shares, since these are the ones that attract tax relief.
    • This means there will be no spread or commission (or stamp duty), though there is usually an initial charge instead (of 1% to 2%).
    • ITs are like any other share, and there will be a spread, a commission and stamp duty to pay.
  3. The third cost is the annual charge.
    • For all fund types, this will normally be in the 1% to 2% pa range.

What’s in it?

As we said at the top, an equity is a share in the ownership of a company, and in its future earnings.

  • Private Equity is a share in a company that isn’t listed on a stock exchange.

There are several flavours of Private Equity:

  1. “Real” Private Equity, where you join a partnership that invests in unlisted companies.
    • A less formal version of this is Angel investing.
    • And a modern spin on this is Crowdfunding (not recommended).
  2. Tax wrappers for Private Equity such as VCTs, EIS and SEIS.
    • These deal with early stage funds and lock your money away for at least 3 to 5 years.
    • In return you get 30% up-front income tax relief and some other tax breaks.
  3. Investment Trusts (ITs) which act like listed versions of Private Equity partnerships.
    • These can invest in large firms or small.
    • Recently there has been a trend towards intellectual property firms and university spin-offs (Woodford Patient Capital is probably the best-known example).
    • You can find around 20 of these trusts on our Investment Trusts Master List.
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Private Investors would be best to stick to ITs, or if you need the tax relief, VCTs (and EIS funds).

What does a good one look like?

A good diversifying investment is one that performs well.

  • It should deliver returns close to those of equities, with a low correlation to equity returns.
  • Unfortunately such investments are hard to identify in advance.

The main ITs and VCT providers have long track-records, and you will need to rely on these (as well as on diversification).

  • EIS funds are newer, and the leaders have yet to emerge.

What does a bad one look like?

A bad Private Equity investment is an undiversified one, and / or an illiquid one (unless you’ve been rewarded for the illiquidity with tax breaks).

Stay away from crowdfunding and Angel investments and that’s more than half the battle.

Any recommended brands?

The brand leaders will vary over time, but VCT providers like Baronsmead and Northern have good records.

  • I’ve personally invested with around 15 VCT providers and don’t have too many complaints.

Leading ITs include 3i, HgCapital, Electra, Pantheon, Standard Life, Princess, Dunedin, Candover, Apax and Woodford.

What are the main risks?

Private Equity (PE) shares the key risk of all Equities that the owners of shares rank last in terms of their claim to the assets of the company.

  • This means that you do well when the company does well, but very badly when the company does well.
  • Since most PE investments are in small and young firms, this risk is even greater than with most listed Equities.

The price volatility that puts most people off listed Equities is much less of a factor with Private Equity since PE assets are hard to value and will be revalued infrequently.

So liquidity becomes the main issue.

  • You can’t get your money back until there is an exit (typically a takeover or a listing).

How do you deal with these risks?

The inherent riskiness of PE investments is best addressed through diversification.

  • Buy funds (like ITs and VCTs / EIS funds) rather than make individual investments.
  • Buy several funds rather than just one.

ITs don’t have a liquidity problem (since they are listed on exchanges)

EIS and SEIS are not listed – and are illiquid.

  • With EIS / SEIS, you are paid to take on the lack of liquidity through tax breaks.

VCTs are listed and in small size (below £10K perhaps, and certainly below £5K) they are reasonably liquid.

  • You still get the tax breaks, though.

You should always remember that Private Equity is intended to make up only a small part (5% to 10% at most) of your overall portfolio.

  • You will also need Growth assets (Equities) and Defensive assets (Bonds and Cash), as well as other Diversifying assets (Property and Commodities).

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 39 years, with some success.

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Private Equity – Elements 25

by Mike Rawson time to read: 6 min