PE Gets Tested

Private equity has lost its easy leverage...

PRIVATE EQUITY has grown ever more popular in recent years. But its touted benefits are set to be tested, says John Stepek at MoneyWeek magazine.

Private equity, put simply, means investing in companies that aren't publicly listed.

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.

As Mohamed El-Erian put it in the Financial Times recently 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.

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.