Asset allocation has historically focused on traditional asset classes—public equities, fixed income and cash instruments. However, given the outlook for continued modest traditional market returns and rising inflation, investors are increasingly looking at private equity to improve portfolio performance over the long term.
But what is private equity (PE) and how do investors participate in the potential growth of the asset class?
Private equity refers to equity capital that is not listed on a public exchange. It is capital that is provided by an individual or institutional investors to fund a potential company at various stages of its life cycle, from start-ups through to mature companies. The company may then use the capital to acquire assets, fund new technology, expand its working capital and/or improve its balance sheet.
Private equity strategies are wide-ranging. But they all share a common trait—capital structure optimisation combined with long-term investment horizons and hands-on management support. The core of private equity growth and ability to generate high returns lies in its standard practice of acquiring businesses, guiding them towards positive transition and then selling them. As a result, the holding period of PE investments is typically three years or longer, and it is difficult to divest at short notice. In fact, it may take as long as 7 to 10 years for a start-up to grow large enough to do an IPO.
In part, due to its longer investment timeframe, private equity offers one of the highest expected return, albeit with the highest risk, among major asset classes. The high-risk and high-return is also to compensate investors for assuming illiquidity risk.
Types of private equity investment
Generally, private equity investment opportunities fall into two main categories—corporate finance and venture capital.
Corporate finance involves investing in existing companies, and the strategies might include funding a company to support its expansion restructuring, consolidation or turnaround.
Venture capital implies funds that invest in start-up companies, and typically these could be categorised into seed, early-stage or growth funding. The idea of such funding 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.
Seed capital, as the name suggests, is the initial capital, and it is usually the founders’ personal assets, or funding, that has come from friends and family. Seed capital may also come from professional angel investors through a loan or buying a stake in the company.
Typically banks and capital providers may wait until the business is more established before making any investment. One factor that makes private equity attractive is that an investor may provide financing as well as have a say in the strategy and management of the company. Each private equity investor has different standards for participation and levels or capital commitment.
Following seed capital comes early stage investment—sometimes called Series A or B funding. At this stage the founders would have already used their seed money to provide a “proof of concept,” or evidence, demonstrating that their business concept is viable and will eventually be profitable. Series B will follow Series A and these financing may range between $5 and $20 million or more and may come for corporate or individual investors.
Later-stage financing (Series C, D and so on) may also raise similar or larger amounts. After the company has grown in size and its business is well-established, mezzanine capital is sometimes provided by private equity firms, either as debt or a convertible note just prior to the company’s IPO.
Investors earn cash from a private equity investments through dividends, which typically occur after the company is profitable and part of the profit can be divided among the shareholders. Aside from that, an investor can make money when he sells his shares. This will occur normally upon a company exiting through a trade sale, a company buyback, or through listing on a stock market.
Private Equity in Asia
In 2017, global private equity deal volume rose 14%, surpassing $1.2 trillion, according to a report by McKinsey. Asia led the charge as deal volume jumped 96%, to $110 billion. This dramatic growth is not surprising for the region’s maturing private equity industry and reflects several larger deals in China, Korea and Japan. The market in Asia is rapidly changing due to a fast-growing middle class, increasing urbanization and booming economic growth, especially in emerging markets.
Being a company that uses AI and blockchain technologies, our expertise and knowledge are in the fintech sector, and this sector has seen dramatic growth in recent years. Based on a report by CBInsights, venture capital-backed fintech companies raised $5.4 billion across 323 deals globally in the first quarter of 2018 as deal activity hit a new quarterly record. The U.S .saw the largest boost in deals, while Europe saw fintech deal activity dip to a five-quarter low.
Asia’s fintech funding saw the most significant quarterly spike in the first quarter on the back of four $100 million plus investments. Among the largest fintech deals in the first quarter is $650 million of funding raised by Ping An’s OneConnect, valuing it at $7.4 billion. The China-based company sells technology platforms to smaller banks. Another high-profile company is China’s credit assessment solutions provider Wecash, which completed US$160 million of Series-D financing. The financing was led by ORIX Asia Capital Ltd and SEA Group.
How to be successful in private equity investments?
So how should investors gain exposure to private equity? Let’s be bluntly honest here. Private equity investment isn’t easily accessible by anyone and everyone. Unless you are a ultra-high net worth individual, most private equity funds across the world are generally exclusive and inaccessible to most investors due to the large investment sums required, long holding periods and lack of access to quality fund managers.
Being a FinTech asset management company, we help investors allocate funds to different targets, and our track record speaks for itself. Our past investments in various U.S. and Asian companies have enabled our investors to access to quality companies. Although they do need to understand what constitutes private equity investment, they do not have to be filthy rich to gain the “privilege” of accessing the asset class.
While many investors would be hesitant about investing in a “unicorn company” (a startup with a valuation of more than US$1 billion), our view is that with the right due diligence and research, the best time to invest is before a company develops into a unicorn. It is never about the label, but more about the investing skill and the management of the capital.
A wide range of expertise is required to be successful in private equity investments. These skills include amongst others industry knowledge, financial modelling, risk control, familiarity with legal and compliance regimes. In fact, only 40 out of 100 Asian start-ups would be successful, and for those 40 companies to be successful investments, they have to be able to create an average 25-30% IRR (internal rate of return) each year for the entire initial invested capital. In other words, they must be able to increase investors’ return by around four times over six years.
It is our view that the region has a vibrant start-up scene as entrepreneurs are constantly emerging with new ideas. Opportunities abound for the investor with the right access to and expertise in the private equity sector.