Private equity strategies provide investor opportunities

For private equity investors, the secondary and small- and mid-cap buyout markets may be promising, says Morgan Stanley

Private equity funds have become more mainstream among investors looking to diversify away from traditional equities, Morgan Stanley Wealth Management said in a recent note.

“Once considered a boutique investment, private equity assets under management have swelled fivefold in the last 15 years, to $2.4 trillion [US] as of December 2015,” the note said.

According to Morgan Stanley Vice President Rafique DeCastro, pension funds have had to shift more toward alternatives so that they could reach their return targets. Consequently, “billions of dollars have poured into the asset class,” he said.

A main disadvantage of private equity is its illiquidity: typical private equity investors are locked in for years, unable to redeem their funds until the underlying investments bear fruit. In recent years, investors have been able to access options that sweeten the pot for them.

One is the secondary investment market: essentially, this opens up the option to buy and sell existing private equity commitments, which lets investors invest in a fund during its later years, during which gains tend to cluster as shown by a chart called the J-curve. Since the fund is in its maturity, secondary investors also have a clearer idea of what the fund portfolio contains. The secondary market, according to statistics cited by Morgan Stanley, was worth US$25 billion in 2011; it peaked at US$42 billion in 2014, and dipped slightly to US$40 billion in 2015.

Another option is to access the small- and middle-market buyout market, as opposed to large-caps. The rapid growth of private equity has caused deal multiples to go up, and “there's more capital accumulating on the sidelines as managers look for deals,” according to the note. Since multiples have historically been fairer for the lower-to-middle segment, investors can take advantage of greater inefficiencies in pricing of underlying assets, which can potentially give investors better returns.

Of course, performance depends a lot on the manager of the fund. “None of this matters if you don't select the right manager,” said Morgan Stanley Executive Director Al Troianello. “It's more than just track record, it's the people and process they have. If a manager has a good track record, hopefully they weren't just lucky but rather there was a solid reason behind that track record.”

Related stories:
While private equity slows, venture capital soars
Private equity offerings being sweetened through time