The benefits of private equity are about to get tested

Keep your asset allocation simple

(Image credit: © Getty Images/iStockphoto)

published 27 June 2022

Private equity – put simply, investing in companies that aren’t publicly listed – has grown in popularity as an asset class over the last few years. Advocates point to the fact that private equity returns are simultaneously at least as attractive but less volatile than stockmarket returns (in other words, investors endure fewer ups and downs). Detractors note that this is purely down to the use of borrowed money, a lack of liquidity, and the absence of “mark-to-market” accounting, not to mention a more recent trend towards certain funds effectively re-selling assets to themselves at favourable terms and prices.

Cutting through the debate, however, one thing is hard to dispute. In an environment in which we’ve gone from frenzied boom to painful bust for “growth” companies, and in which interest rates and inflation are both rising, it’s hard to imagine any realistic scenario where private company valuations haven’t suffered too.

Mohamed El-Erian: inflation, disinflation and the mistakes of central bankers

As Mohamed El-Erian put it in the Financial Times last month, it’ll be harder for private equity firms to borrow money to take firms private, and wobbly equity markets also mean that exit valuations “are less certain”. That’s before you even start to consider the pressures the new environment places on the portfolio companies themselves. It’s quite possible that some have been purchased at valuations which they will never be able to justify, regardless of holding period.

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Don’t overcomplicate things

So what does this mean for you as an investor? Firstly, it’s a useful reminder that as private investors we have the luxury of keeping our asset allocation simple. You’re not running a pension fund and thus have no need to justify your existence by buying into overly-complex (and expensive) strategies.

At MoneyWeek, we suggest you think in terms of just five asset classes: bonds, equity, property, cash, and gold. They each have different qualities which make them useful under different economic circumstances. In this context, private equity is part of your equity exposure, and not something you “need” to own as a distinct asset class.

Secondly, it also implies that even if you are tempted to invest in private equity, you might be best to wait it out for now. For example, discounts on private equity investment trusts have expanded this year. But that might simply reflect concerns that the value of underlying portfolios will be written down.

As El-Erian points out, “historically, revaluations have tended to lag behind public markets by a minimum of six to nine months”. So there may well be better opportunities to buy in the future.

SEE ALSO:

What is private equity?

Private equity – the new kings of Wall Street

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.