Many investors think “Private Equity” is an asset class reserved to Wall Street billionaires and Silicon Valley titans. That’s not right – but those billionaires and titans have private equity in their portfolios for good reasons.
Like all other investments, private equity has its own unique attractions and risk factors. It isn’t for everyone, but more stock investors should take a look. The category has much to offer.
Reason #1: Better Value
Suppose you have money to invest and you want to buy a small business. You find one that looks like a good prospect. The current owner agrees to talk.
You learn that in recent years the business made profits, after payroll and other expenses, of approximately $1 million per year. Prospects for the next few years look about the same. You decide to make an offer and ask the current owner for a price.
The asking price: $16 million.
Are you tempted? Probably not. You like the business, feel confident it will do well, but $16 million is way too much when $1 million a year is all you expect to earn. You’d need 16 years just to break even – and that assumes nothing goes wrong.
A more reasonable price might be in the $3 million to $5 million range. Buying a business at 3x earnings, 4x earnings or 5x earnings gives you a good shot at recovering your cost and earning a profit within a few years.
Would anyone pay 16x earnings for a profitable business? Yes, they would.
People do it all the time, whenever they buy an S&P 500 index fund. The combined forward-looking price/earnings ratio for those 500 companies is about 16x. That’s a little above average, but certainly not “expensive” by public market standards. It was up to 24x in the 1990s dot-com craze and as low as 10x in the 2008 financial crisis.
This raises an important question. Why do investors willingly pay so much more for publicly traded businesses than for the same profits generated by a privately-owned business?
The answer: buying stock in a public company gives you additional benefits beyond just a share of the profits. For one, you don’t have to buy the whole company. You can buy as little as one share if you wish. This isn’t possible in most private companies.
Another benefit is liquidity. You can buy and sell shares of a public company any time the stock exchange is open. The price will vary, but the exit door is always right there if you ever want to use it.
Again, this isn’t true in a private company. You can’t sell your shares unless you find a buyer. It’s possible but takes time and effort. A few mouse clicks won’t do the trick.
Liquidity isn’t free. If you want the ability to invest in small increments and sell anytime, you have to pay for it. You do so via that higher profit multiple.
Reason #2: More Choices
Investing in private companies vastly expands your choices, too. The U.S. has millions of small and mid-size companies but only about 6,000 have publicly traded stocks. The vast majority of successful businesses are privately owned.
If your goal is to be a long-term shareholder, participating alongside management as the business grows, then the liquidity of owning a public company ought to be a secondary consideration. Far more important is that the company has superior leadership, sound financials and a solid business plan.
Those characteristics are all rare individually. Finding all three in the same company is harder still. Beginning your search by instantly ruling out 96% of the candidates simply because they aren’t publicly traded makes little sense. Yet that is what most investors do.
Private Equity investments give you access to a kind of “emerging market” right here within our own borders. Like foreign markets, information gaps and irrational fears deter most investors. That means not only more choices, but less competition for the best ones.
Reason #3: More Information
One of the benefits of owning stock in a public company is that regulations require them to release certain information. Shareholders receive quarterly and annual financial statements as well as other important company news.
This visibility has a downside, though. For one, everybody else gets the same information at the same time. Investors try to react quickly, leading to hasty and often wrong decisions that can hurt other shareholders.
Another issue is that companies tend to release only the information required by law. If you want to know more, you are out of luck. Securities law and liability concerns encourage them to say as little as possible beyond what they must.
In a private company, with only a handful of shareholders, managers have much more flexibility. Large investors can demand – and receive – free access to the company’s financial records. They can speak with officers and directors. Management treats shareholders as long-term partners.
How to Learn More
You may have heard of Blackstone Group or other famous private equity companies. They raise money mostly from large institutional investors, then use it to buy entire businesses. Other firms offer similar services if Blackstone is out of your league.
Finding those providers can be a challenge. Securities regulations often prevent them from advertising or soliciting investments publicly. It is a network-driven market where investors usually learn of opportunities through friends and business associates.
At Republic, we’re familiar with private equity investments and how to gain access to them. We offer clients unbiased advice on the advantages and disadvantages, and can help you decide if private equity is appropriate for your financial situation. Feel free to ask us during your next account review and we will tell you more.
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