Why we believe private equity is a better ownership model
Investor participation and interest in private equity continues to grow. Investors are attracted to private equity for different reasons, including access to the significant investable opportunity set that exists across the universe of private companies, along with lower volatility when compared to public equities. That said, arguably one of the most attractive benefits is the potential for greater returns relative to public markets. Indeed, Hamilton Lane finds that buyout pooled returns have outperformed on a public-market equivalent basis against the MSCI World Index for all but one of the last 20 vintage years.1
What’s driving this consistent outperformance? We argue that one of the key factors at play is that there is a strong relation between private equity outperformance of public equities and the private equity ownership model. Bottom line: from our vantage point, private equity is a better ownership model compared to public company ownership. In this blog post, we'll outline some of the key reasons why we believe this to be the case.
Alignment of interests
Public companies have many shareholders and stakeholders with diverse interests that are dependent on their relationship with the company. This dynamic has the potential for conflict - such as in merger and acquisitions negotiations - thereby distorting decision making processes. In contrast, within private equity owned companies, there is clear alignment between company owners and company management that is focused on creating and maximising value. This clarity of mission and alignment of interests is supportive of the company’s success over the long-term.
The lifespan of a typical private equity fund is generally 10 or so years, with the option of two one-year extensions at the discretion of the manager. In addition, on final close of the fund, the manager typically has a predetermined window of opportunity in which to make new investments, which usually lasts four years. The implication for investors is that under this structure, private equity managers can be patient with both the entry and exit of their underlying portfolio companies. Depending on market conditions, at any given time private equity managers can either slow down or accelerate capital deployment and exit activity. They can also be disciplined around exit path - e.g., initial public offering (IPO), strategic buyer or other private equity sponsor - and can exit at a time of their choosing in order to maximise value. In contrast, public equity owners have the ability to buy and sell investments on a daily basis, and some may be prone to chasing performance. Indeed, impatience can be more expensive if an investor locks in losses by selling assets at a lower price than originally acquired and using those proceeds to invest in securities / funds that have enjoyed strong recent performance.
A license for action
When compared to public company boards, the boards of private equity portfolio companies have a greater tendency to take a co-leadership role with the CEO on critical issues such as strategy and the performance of the business. This heightened level of engagement is effectively a license for action facilitating the impetus and freedom to make decisions and implement changes that are focused on creating value over the medium to long term.2 Another contributing factor is the concentrated ownership structure of private equity owned companies - with an engaged board, key decisions can be voted on quickly without the need to convince a wide range of different shareholders with diverse interests.
Given public equites are traded daily, their value at any given point in time is not only a function of company specific factors, but also other influences, such as investor sentiment or macroeconomic influences. As all of these variables are accounted for in real time, company valuations change more frequently relative to their private counterparts. In the case of private assets, there are generally no observable prices that can be utilised to value an asset. As such, private equity managers typically use a consistent process that was developed by the Financial Accounting Standards Board in order to determine the fair value of their investments. This methodology utilises three main inputs: public market comparables, private transaction comparables and discounted cash-flow models.3
While private equity managers may weight each of these variables differently, and some may be more conservative / aggressive in adjusting valuations, there is a degree of uniformity in how private asset valuations are determined throughout the industry. Moreover, private equity valuations are struck on a quarterly basis - a process which typically takes weeks - and as a result, valuations are not available until approximately 45-60 days following quarter end. In the event of major market dislocations, investors are not likely to see the impact on their private asset values until two or three quarters, therefore cutting the noise associated with public market valuation volatility.
Ability to creatively structure transactions
A key feature of the private equity ownership model is the ability to creatively structure transactions that have the potential to solve issues associated with buying and selling a given company. For instance, the founder/owner of a company may be looking to monetise some of the value created in the business, but not yet be willing to give up all ownership, rather preferring to remain involved in the business and aligned to its economics in the future. Examples of creative deal structures include:4
- Contingent considerations/earn-outs – Deals offering additional payments to the seller if the business achieves pre-defined thresholds
- Equity clawbacks – Provisions that give the selling party the right to purchase equity at a pre-determined value if certain conditions are met
- Performance-based stock awards – Equity awards that pay out if specified company performance targets have been achieved
The bottom line
It is not surprising that as investors seek to address the challenges of generating returns, improving diversification and reducing portfolio volatility they are increasingly turning to the private equity asset class to improve their investment outcomes. As we have discussed, it is the private equity ownership model that factors into to the consistent superior performance that private equity has delivered compared to public equites historically - and which we believe will persist into the future.
1 McKinsey & Company, McKinsey Global Private Markets Review 2021, April 2021.
2 McKinsey & Company, Climbing the Private Equity Learning Curve, May 2021.
3 How Private Market Valuation Methodologies Help Temper Volatility, July 2020 https://icapital.com/insights/private-equity/how-private-market-valuation-methodologies-help-temper-volatility/
4 MCM, Creative Deal Structures for Extraordinary Times, April 2020 www.mcmcapital.com/2020/04/creative-deal-structures-for-extraordinary-times