Why We Believe in Investing in Private Equity

Once the shining star of ‘alternative’ investments, private equity has recently faced increased scrutiny and shifting fortunes. With increased scepticism, high-profile institutional investors reducing their exposure, and headlines proclaiming the decline of private equity, this asset class stands at a crossroads, provoking fresh debate over its actual value in modern portfolios. The allure of private equity has always been its potential to deliver higher returns, diversification, and access to unique investment opportunities. However, these attributes are now being called into question given the headwinds facing private equity and the recent struggles of the asset class to return capital to investors.

As per our investment approach here at Northwood Family Office, we attempt to move beyond the short-term ‘noise’ around private equity, and instead, we take a balanced view examining the longer-term attributes and the drawbacks of investing in private equity. In this note, we also highlight some best practices in our approach when incorporating private equity into a portfolio.

One of the primary attractions of private equity is its potential for outsized returns compared to public markets. Private investments are generally less liquid, meaning investors cannot easily buy or sell their holdings on demand. In return for accepting this risk, investors typically expect — and have historically received — an "illiquidity premium," or higher returns compared to more liquid public assets. This premium compensates for the inability to quickly exit an investment.

However, with interest rates increasing dramatically starting in 2022, this headwind of higher interest rates has depressed private equity returns and caused the asset class to lag its public market equivalents. This has led some to question the value of allocating to this asset class. Recent shorter-term underperformance notwithstanding, we continue to believe in the ability of private equity to generate enhanced returns above public markets over a market cycle. Supporting this view are the sources of return enhancement that private equity can access, which include the following:

Access to Unique Investment Opportunities

Private equity exposure provides access to a broader range of opportunities. It is estimated that 87% of companies in the US with revenues over $100m are private companies.¹ This means that if you limit your investing scope to publicly traded companies, you’re missing out on the opportunity to invest in almost 90% of US companies with annual revenue of $100M or more. Private equity investing opens the door to investments in earlier-stage companies, specialized industries, and companies unavailable through public exchanges. Such opportunities may provide access to innovation, niche sectors, or long-term secular growth trends.

Active Ownership and Value Creation

Investors in private equity often gain significant influence over the companies they invest in by taking a controlling ownership position. This active ownership model allows for hands-on management, operational restructuring, and strategic decision-making, which can unlock hidden value and drive superior outcomes. Private equity managers typically work closely with management teams to implement growth initiatives and improve efficiency.

Improved Valuations

Private equity investors often acquire companies at valuations that are more attractive, meaning the price paid relative to earnings or other financial metrics is typically lower than for comparable public companies.² This is partly because private businesses may not have the same visibility, scale, or access to capital as their public counterparts, leading to more favorable pricing for buyers willing to perform in-depth due diligence.

Entering at lower multiples can provide a cushion against downside risk and create a tailwind for future returns. As private equity managers drive operational improvements and strategic growth within these companies, the potential exists to sell the investment at a higher multiple down the road, particularly if the company is brought to public markets through an IPO or sold to a strategic acquirer. This process, often referred to as “multiple expansion,” is a key tool for generating value and enhancing returns.

Portfolio Diversification

Beyond the return enhancement argument, private equity exhibits lower correlation with public market movements. This means that including private assets in a portfolio can reduce overall volatility and improve risk-adjusted returns. One criticism regarding this point is that the lower volatility is only because private equity assets are not marked-to-market on a daily basis the way that publicly traded stocks are. While this argument holds some truth, it does not undermine the potential for enhancing portfolio diversification by engaging with sectors and industries inaccessible to public market investors.

Additionally, the lower volatility from not marking-to-market asset valuations may actually reduce adverse behavioral tendencies for investors who may be prone to overreacting to short-term volatility, leading to more disciplined long-term investing.

While the prior points illustrate the positive aspects of private equity markets, it is crucial for investors to also understand the limitations of private equity exposures.

These drawbacks include the following risks:

Limited Liquidity and Longer Investment Horizon

The flip side of the illiquidity premium is the significant challenge posed by the inability to sell private assets easily. Investments in private equity funds often require locking up capital for years (sometimes a decade or longer), with limited options for early redemption. This restricts an investor's ability to respond to changing market conditions or personal liquidity needs.

To realize the full value of private market investments, investors must often commit capital for extended periods. Unlike public stocks or bonds that can be traded at will, private market deals may not generate liquidity events (such as IPOs, mergers, or takeovers) for many years. This longer time horizon requires patience and careful planning to avoid mismatches with an investor's overall financial objectives or cash flow needs.

High Minimums and Limited Access

Many private equity investments are accessible only to institutional investors or those who meet high net worth or accredited investor standards. Minimum investment amounts can be substantial, creating barriers for individual investors and limiting the ability for investors to diversify across managers and vintage years within the private equity asset class.

Lack of Transparency

Private markets are subject to less stringent regulatory oversight and disclosure requirements than public markets. Information about fund holdings, valuation methods, fees, and performance may be limited or reported infrequently. This opacity increases the risk of mispricing, fraud, and manager misconduct, and makes it harder for investors to evaluate the merits of a particular investment or manager.

Complex Fee Structures

Private equity funds typically charge higher and more complex fees than public market vehicles. In addition to management fees (often around 2% per year), investors may pay performance-based incentives (commonly 20% of profits, known as "carry"). Additional expenses for transaction, administration, or monitoring may further erode net returns.

Difficult Performance Benchmarking

Because private assets are not traded on open markets, establishing fair and accurate valuations can be challenging. Performance is typically reported on a quarterly or annual basis and may rely heavily on manager discretion. Differences in accounting methodologies, reporting frequency, and the idiosyncratic nature of private deals make it difficult to compare returns across funds, vintages, or asset classes.

Best Practices for Allocating to Private Equity

When choosing to include private equity assets in portfolios, several best practices can help manage risks and enhance potential returns:

• Due Diligence: Because dispersion between private equity managers is much greater than in public markets, it is critical that we conduct thorough research on private equity fund managers, investment strategies, and underlying assets prior to allocating client capital.
• Diversification: We seek to spread allocations across different private equity market segments, vintages, geographies, and managers.
• Liquidity Planning: We attempt to align private market exposure with a client’s overall liquidity needs and avoid overcommitting to illiquid assets.
• Fee Awareness: We ensure we understand all layers of fees and projected net returns.
• Performance Monitoring: We regularly review investment performance and manager reports, even if data is less frequent.

Conclusion

Private equity presents a compelling opportunity for investors seeking higher returns, diversification, and access to unique assets unavailable in public markets. However, these benefits must be balanced against their drawbacks, including illiquidity, lack of transparency, and complex fee structures. The decision to include private market investments should be based on a careful assessment of one's investment goals, risk tolerance, and investment horizon. While recognizing the limitations of private equity, we maintain our belief that for affluent investors with a sufficient time horizon, private equity exposure will continue to enhance total portfolio outcomes.

In this current climate of negativity and calls heralding that the decline of private equity is upon us, one may be reminded of Mark Twain’s response to rumours of his demise – “The reports of my death are greatly exaggerated.”