Private Equity: The Natural Alternative for Entrepreneurial Investors
In their own businesses, entrepreneurs tend to aim high and develop a keen understanding of how to balance risks and returns. So when they invest their personal wealth, it is natural that these qualities influence their investment decisions – and lead many entrepreneurs to consider investing in Private Equity (PE) given that many entrepreneurs have encountered PE in some form or another (angel investors, venture capital, growth equity, etc.)
PE investing can feel very familiar to entrepreneurs who have built businesses themselves and can relate to the intrinsic value-add of experienced fund managers beyond capital, namely information, experience and relationships to peers and competition, especially in a different market or geography. But there is another, more fundamental, reason to include this asset class in a portfolio: diversification.
Last year was extraordinarily volatile for public markets. After collapsing as the covid-19 pandemic began, stocks recovered spectacularly. The US stock market, as reflected by the Russell 3000 Index, climbed 20.9% during the whole of last year, while emerging markets as measured by the MSCI Emerging Markets Index rose by 18.3%. Even bond markets did well: US 10-year Treasuries returned 10.01%.
If markets revert to their historic, less extreme levels of volatility, entrepreneurs in search of better-than-average performance may benefit from including alternative investments like PE in their portfolios. Research by BNP Paribas Wealth Management casts fresh light on entrepreneurs’ attitudes toward this asset class.
The Private Equity Premium
History demonstrates that during downturns, PE strategies outperform public markets even more than in ‘normal’ circumstances. BNP Paribas research shows that in stable markets, PE beats the stock market by approximately 6% a year – and after the internet bubble crash in 2001 and the Global Financial Crisis (GFC) in 2008, PE’s outperformance increased. This resilience compounds over time: PE returns over the last 14 years have been on average 13.6% a year compared with 6% for the S&P500. It is perhaps not surprising that family offices increased their allocation to PE from 20.7% in 2013 to 25.6% in 2019. This accounts for partially for the surging investor inflows that pushed the size of the overall private capital industry to US$7.4 trillion as of end-2020, according to Morgan Stanley and expects that to increase further to US$13 trillion in 2025.
In the uncertain recovery scenario following the covid-19 crisis, PE should continue to appeal to entrepreneurs because of its propensity to deliver higher returns and the diversification it offers. According to our research, ‘ultrapreneurs’ – or entrepreneurs with investable assets of more than US$ 25 million are most likely to perceive the potential in PE: in 2019 they anticipated doubling their allocation to the asset class from 10% to 20% in 2020. 75% of entrepreneurs hold PE investments, which comprise 14% of their portfolios.
The covid-19 pandemic that profoundly disrupted global markets in 2020 also affected the ability of PE managers to attract funding: in the US, total fundraising fell 36%, but even so, raised US$203 billion in new commitments. Funds focused on companies with growth potential despite the challenging economic conditions still reached new records: 45 funds focused on technology investing attracted US$63.1 billion, the highest ever for such fund. This points to the fact that the pandemic has resulted in an acceleration of the digitalization trends by several years. As an example, there are 5.2B unique mobile phone users (67% penetration out of a global population of 7.8B), 4.5B internet users (59% penetration) and 3.8B people making e-payments representing US$1 trillion of payment value.  Many of these new commitments would have been funded by investors that fall into two broad categories
1) those seeking resilient assets during the year’s extraordinary volatility and
2) those seeking higher returns in a low interest rate environment.
Diversification is a key feature of these investment strategies, reducing correlation with equities and fixed income markets to introduce a stabilising effect to portfolios. PE’s proven resilience in times of market stress can mitigate unforeseen events, sustaining performance when other assets are falling. More than 40% of entrepreneurs cite diversification opportunities as a reason to invest in PE; for women in particular, it is the main attraction, with nearly 50% rating it highly. It is also the top attraction for those with between US$10 million and US$25 million in assets.
Comfort with risk
But PE also poses some challenges. These include less transparency and liquidity than is found publicly listed markets, as well as exposure to often highly leveraged assets. The absence of the kind of disclosure normal in public markets is a barrier to investing in (or increasing) PE allocations for 37% of entrepreneurs globally. In Asia, 50% of entrepreneurs overcome this challenge by conducting their own research into each opportunity.
Many entrepreneurs feel comfortable with these risks because they have strong convictions about trends in different industries and want to support business models that reflect those views. Many are comfortable committing to PE’s medium- to long-term investment horizon for the same reason.
In Asia, Ultrapreneurs in mainland China, Hong Kong, and Singapore perceive the fewest barriers to investing in PE. This could be because many have built their wealth in entrepreneurial businesses and are therefore familiar with the risk-return proposition. Youth also plays a role: 71% of ‘millenipreneurs’ (aged under 35) and 83% of ‘Gen-X entrepreneurs’ (born between 1965 and 1980) are likely to choose PE investments. By contrast, just 45% of ‘Boomerpreneurs’ (those over 55) are willing to engage with the asset class.
Funds versus direct investment
Many investors seek to mitigate the risk of individual PE investment by accessing the asset class via funds, which offer exposure to a wide range of strategies. For example, growth capital funds that invest in more mature companies seeking capital to expand or restructure are most popular with entrepreneurs in Europe and the UK (54%) in our survey. Asian entrepreneurs prefer thematic funds (43%) which enable them to exploit lucrative or emerging macroeconomic trends. Those in the Gulf region prefer buy-out funds (50%) and venture capital funds (50%).
Some entrepreneurs have the risk appetite to make direct PE investments, though, and many of these look to their banks to help them access harder-to-find prospects. For 34% of entrepreneurs globally, their relationship manager is a key resource in this process.
Across Asia, entrepreneurs also look to other entrepreneurs to source PE investments – 48% of entrepreneurs in Singapore, 42% in China, and 38% in Taiwan said they felt confident using their own contacts to do this. However, we do advise caution for these type of direct investments which are typically local and more often than not are related in some form or another with the core business of the entrepreneur. If so, these types of investments will not bring the diversification benefits such as by sector or geography to one’s portfolio.
While our survey demonstrates the broad and enduring appeal of PE, experienced investors would be aware that these asset classes do not guarantee outperformance. Indeed, PE can deliver very variable returns depending on which managers an investor backs. On average, the dispersion between the top and bottom quartiles is around 1,500 basis points since 2000. Thus the manager selection and access to such top-tier managers is the key to a successful partnership in PE.
This wide variation in performance is another reason why due diligence and market research is critical before committing funds to PE. The asset class has a natural and logical appeal to entrepreneurs, but partnership with an experienced Wealth Management advisor can help them identify the right approach and build a portfolio that matches their risk appetite and needs.
 Private capital industry soars beyond $7tn. Financial Times, 11 June 2021