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Private Equity - Investors Academy

 

What is Private Equity?

The term sounds complicated, but is actually quite straightforward. Private Equity means owning shares in companies that are not listed on the stock exchange.
It is a strategy that should be considered as an addition to a diversified portfolio, because the potentially higher return is associated with high risk and low liquidity. This lack of liquidity is one of the main risks that stands out when looking at Private Equity as an asset class, given that these investments are difficult to sell before the investment horizon has fully expired.

This long-term investment (more than 10 years) may be chosen by a company for a variety of reasons, some of which are listed below:

  • Development of new products and technologies
  • To strengthen the balance sheet structure
  • To increase working capital

When an investor decides to invest in Private Equity, it means they will be holding a stake in companies for a specific period of time in order to achieve a specific growth plan, and to move these companies forward into the next phase of their lives. Once this growth plan is completed, the Private Equity investment is sold and the investors realize their return.

Types of Private Equity

Each company passes through different stages in its life, and each of these stages has its own Private Equity strategy associated with it. The spectrum ranges from high-risk start-ups to relatively defensive investments in mature companies.

  • Venture Capital are investments in young companies who seek funding te be able to develop their business further (early stage). As a result, these investments generally carry a higher risk, but potentially also a higher return.
  • Growth Capital focuses on companies with a high growth potential. These companies are looking for more cash to enable further growth, whereby this development capital they acquire allows them for example to open an additional branch abroad, do an acquisition or increase their production capacity.
  • Capital transfer (Buy-out) is a strategy that buys out mature and profitable companies. A majority interest is often used as the way to revise the company's strategy and/or its operational activities.

When choosing a strategy, and therefore also when choosing a company in which to invest, it is essential to collect sufficient information about the company itself.

How to invest in Private Equity

Due to significantly higher entry levels compared to traditional investment funds, investing in Private Equity is not available as a direct investment to most private investors. As a solution to this, ABN AMRO Private Banking offers funds that spread the invested capital over a basket of around 10 to 20 promising companies. This reduces the risk that would be associated with investing in an individual company.

Another option is investing in funds of Private Equity funds. In this case, the capital invested is distributed across a number of Private Equity funds, so the investor's cash reaches a wider variety of companies via the underlying shares in the funds. This means a higher degree of diversification and a better spread of risks. In order to realize the full potential of Private Equity for portfolio diversification, it is advisable to gradually build up a Private Equity portfolio that is spread across a number of different Private Equity funds, strategies and regions.

Private Equity funds have some typical characteristics. The investor enters into a subscription agreement (also referred to as "commitment") with the fund. By doing so, they agree to contribute to all requests for more capital (also known as "capital calls") by the management company over the entire investment period. The total amount invested is therefore gradually paid in during the investment phase.
Capital distribution is when capital is repaid to investors through dividend payments or via the redemption of shares, for example. These payments are therefore not reinvested, but are paid out to the investor. At the end of the investment phase, the investor will continue to receive distributions until the last company has been sold. 

Advantages of investing in Private Equity

A potentially higher return compared to traditional asset classes over a longer period of time.

Diversification and optimisation of a financial portfolio. The risk/return ratio of a traditional portfolio can be improved by including Private Equity investments.

Investments in Private Equity have historically yielded above-average returns compared to listed shares.

Given the lack of a stock exchange listing you, as a shareholder, are not exposed to sometimes significant price fluctuations, often driven by sentiment. This is a significant advantage compared to volatile stock markets.

 

Risks of investing in Private Equity

  • Liquidity risk
    Investing in Private Equity requires an investment horizon of 10 years or more, with an average capital commitment of 5 to 7 years. Due to this long period of time, the main risk of Private Equity is the lack of liquidity, as it is very difficult or even impossible to trade the product during this period.
  • Market risk
    The market risk depends on the companies or funds in which you invest. If the value of these companies or funds decreases, the value of your investment will also decline. In addition, there is a risk that the fund manager will invest in companies that do not meet their growth targets or cannot be sold when expected. For this reason, it is advisable to diversify across several companies and/or funds.
    As an investor, it is also essential to gather and accurate information about the companies in which you are investing to avoid any unpleasant surprises.
  • Exchange rate risk
    An exchange rate risk occurs when the Private Equity fund is denominated in a foreign currency or when investing in underlying assets listed in a foreign currency. If the value of that foreign currency declines, you run the risk of being paid out less than your original deposit in your home currency.
  • Counterparty risk
    The risk that a counterparty involved in the Private Equity fund is unable to meet their obligations.
  • Interest rate risk
    The risk of fluctuations in the valuation of index-linked products or products that involve interest rates.
  • Emerging market risk
    Emerging or less-developed countries may have to deal with greater structural, economic or political challenges than developed countries.
 

Costs and taxes in Private Equity

  • Subscription fee
    A one-off cost when buying shares in the Private Equity fund. This is usually expressed as a percentage of the capital you commit. The early sale of the Private Equity fund (when this is even possible) may incur additional costs as well.
  • Running costs
    Running costs include the management fee and the performance bonus. You do not pay these costs upon subscribing into the fund. Instead, they are deducted from its net asset value on an annual basis.
  • Custody fee
    The cost of holding your units in a custody account (depending on the type of contract).
  • Capital gains tax
    If more than 10% of a Private Equity fund is invested in receivables, capital gains tax is charged at the withholding tax rate. 

For a recent overview of costs and taxes, please consult our list of charges.

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