MODULE 3: PUBLIC-PRIVATE EQUITY 3.1 Private equity fundamentals

This video explores the fundamentals of private equity. You’ll learn how private equity differs from public equity and what the most common types of private equity strategies are.

Justin Park

Managing director of global client solutions at KKR

7MINVIDEO

[upbeat music]

 

Justin Park, Managing director of global client solutions at KKR

 

The majority of us know about the stock market, it’s in the news every day. But behind the scenes, private equity powers many of the businesses, products and services people rely on daily. There are many more privately held companies than public ones in the U.S. today. 

 

In this video, we’ll talk about what private equity is, what some of the most common strategies are, and what are some of the risks and potential benefits. Let’s dive in.  

 

In the public equity market, investors buy and sell shares in companies through stock exchanges, but privately held companies do not trade on these stock markets. Private equity is a form of investment in which equity is pooled from various sources, such as wealthy individuals, institutional investors or pension funds, and then used to acquire privately held companies or to purchase publicly held companies and take them private. 

 

In private equity, the investors typically acquire a significant ownership stake in the company, often a controlling interest. This allows private equity firms to directly influence the company's management, operations and strategic decisions, with the goal of improving performance. Investors in traditional public equity strategies usually hold a smaller ownership stake and typically do not have direct control over management decisions.

 

One of the most common ways investors get exposure to private companies is through a private equity fund, where the private equity firm acts as the general partner or GP and the investors act as Limited Partners or LPs.  

 

The GP’s role includes fundraising, deal sourcing, portfolio management, value creation and formulating the exit strategy, among other things.

 

The role of an LP is usually passive and revolves around providing capital, sharing in investment returns and relying on the GP to make decisions that align with the fund's strategy and objectives. 

 

It is important to note that private equity investments are less liquid than public equity investments. Unlike public equities that can be traded daily, to allow time for the GP to execute on its value creation plan, private equity typically holds a portfolio company for multiple years. 

 

Historically, private equity funds have not been open to everyone. Many private equity funds tend to have high investment minimums and high investor qualifications. We’ll talk about how the strategic partnership between Capital Group and KKR aims to broaden access to private equity. 

 

Let’s take a closer look at some of the most common types of private equity strategies.

 

[upbeat music]

 

At a high level, private equity strategies often fall into one of three buckets: venture capital, growth equity or buyout. The main differences among these strategies lie in the stage of the company's lifecycle, the level of risk involved and the investment objectives.

 

Venture capital refers to investments in early-stage companies with high growth potential. Venture capital firms are typically minority investors providing capital to companies that are often in their very early stages and have innovative ideas or technologies.  

 

Growth equity investments are typically made in established companies that have already demonstrated a certain level of success and are looking to expand further. These companies might need additional capital to fund their growth initiatives, such as entering new markets, launching new products or making acquisitions.

 

In contrast to the previous two strategies, buyout investments involve acquiring a controlling stake or full ownership of a company. Buyout investors often target more mature businesses aiming to improve the company's operations, increase efficiency and enhance profitability during their ownership period. Expected returns might be lower than with a venture capital investment, but the perceived risk is also generally considered lower. 

 

So, why might someone want to invest in private equity? Private equity has historically outpaced public markets due to the illiquidity premium and the ability to take a long-term, hands-on approach to value creation. While public equities offer more liquidity and transparency, private equity can help complement portfolios by tapping into different return drivers over extended time horizons. And while past performance is not indicative of future returns, the strong return potential has been a main driver of interest in private markets.

 

Private markets are also important for anyone looking to build a more complete equity portfolio.  While public companies are often much larger and may command a larger share of any equity sleeve, there is a vast opportunity set of private companies that offer different investment opportunities that often can't be found in public markets. As we mentioned earlier in the video, there are more private companies than there are public ones, and the gap is widening. 

 

An additional consideration is diversification. Private equity sector exposures often differ from public equity indices, making them a strong portfolio diversifier. For example, many innovative, fast-growing tech companies are staying private longer or going public much later in their lifecycle, which leads to less representation in small cap indices. 

 

You’ll learn more about Capital Group and KKR’s approach to private equity investing, and why we think this is an area worth considering. We hope you’ve enjoyed this lesson. Thank you for watching.

 

[upbeat music]

 

Deepen your understanding

Select each resource below to learn more.

Private equity strategies invest in companies that are privately held and not traded on public exchanges. The most common types of private equity strategies are venture capital, growth equity and buyout. These three strategies can be thought of as falling along a continuum, where venture capital has the highest potential return but also the highest perceived risk, with buyout having a lower potential return but also lower perceived risk.

A four-column graph displays a curved line showing that venture capital strategies cover high-risk, aggressive growth focused investments in early-stage companies with high cash burn rates, while growth equity targets slightly more established companies with positive cash flows and buyouts target mature companies with stable cash flows

For illustrative purposes only

What is venture capital?

 

Venture capital strategies typically make minority investments in startups. One venture capital fund will usually invest in a large number of  businesses, in the hope that a small number of successes will make up for higher failure rates. The aim of venture capital is to help these startups grow rapidly by providing financial support, mentorship, guidance and industry connections. Venture capital investments carry higher risk due to the early-stage nature of the companies involved, where failure is more common, but they also have the potential for substantial returns if the startup succeeds.

 

What is growth equity?

 

Growth equity investors also provide funding in exchange for an ownership stake, but unlike venture capital, they target more established businesses with a proven track record of generating revenue and possibly some profits. These companies will generally have positive cash flow, in contrast to venture capital, where a high cash burn rate is expected. The perceived risk associated with growth equity investments is generally lower compared to venture capital, and the focus is on achieving steady growth rather than rapid scaling.

 

What is buyout?

 

Traditionally, buyout strategies make majority investments in mature companies. That controlling interest can be used to optimize the company’s finances, governance, operations, strategy or some combination thereof to maximize returns for fund investors. Buyout strategies have a lower perceived risk than venture capital or growth equity strategies, but also have lower potential return expectations. Companies included in buyout strategies usually have stable, more predictable cash flows than earlier stage companies.

There are a number of reasons someone may want to invest in private equity, chief among them access to a broader investment universe, the potential for higher returns and potential diversification.

Line chart showing that the number of private companies in the U.S. with more than 50 employees has grown over time, while the number of public companies with more than 50 employees has decreased.

Private companies represent a larger investible universe than public markets. There are far more private companies, both in the U.S. and globally, than there are public companies, even when filtering out the smallest of private businesses. In recent decades, the gap between public and private companies has only grown.

 

Although public markets are larger, the relatively smaller amount of assets currently invested in private equity leaves the asset class with potential room to grow. For a truly diversified, modern equity exposure, it is important to consider both public and private markets.

 

With those different opportunity sets comes the potential for differentiated returns.   

     

In private equity, the manager has the ability to directly impact a business’s operations, staff and strategy in an attempt to create value. This direct control is the key differentiator between public and private equity.

 

Since the mid-1980s, private equity’s returns relative to public markets have been most notable during down-market periods. In some cases, this may be due to differentiated sector exposures, which can make private equity a portfolio diversifier. But private equity funds operate over a longer time horizon, and their holdings’ valuations can be subjective until the time investments are exited, making one-to-one comparisons more difficult.

Bar chart comparing the compounded annual growth return of global private equity compared to the MSCI World Index over 5-year, 10-year, 15-year, 20-year, and 25-year periods.

Past results are not predictive of results in future periods.

It’s important to note that not all managers have achieved the same results. There is a notable return dispersion between different quartile managers, due to differences in skill, strategy, experience and access to quality deal flow, among other factors.

Checkpoint

Now that you have completed this lesson, you should be able to confidently:

 

  • Explain to your clients the three main types of private equity strategies: venture capital, growth equity and buyout.
  • Convey how private equity returns have been steadily notable during down-market periods relative to public markets since the mid-1980s.

Takeaways

Private Equity 101

Download

End of lesson

The next lesson will take a deeper look into the typical lifestyle of a private equity investment and how private equity managers seek to create value.

NEXT LESSON

For financial professionals only. Not for use with the public.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the interval fund prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
For Public-Private+ Funds: Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ are interval funds that currently provides liquidity to shareholders through quarterly repurchase offers of up to 10% of its outstanding shares. Capital Group KKR U.S. Equity+ is an interval fund that currently provides liquidity to shareholders through quarterly repurchase offers of 5% of its outstanding shares. To the extent a higher percent of outstanding shares are tendered for repurchase, the redemption proceeds are generally distributed proportionately to redeeming investors (“proration”). Due to this repurchase limit, shareholders may be unable to liquidate all or a portion of their investment during a particular repurchase offer window. In addition, anticipating proration, some shareholders may request more shares to be repurchased than they actually wish, increasing the likelihood of proration. Shares are not listed on any stock exchange, and we do not expect a secondary market in the shares to develop. Due to these restrictions, investors should consider their investment in the fund to be subject to illiquidity risk.

- Investment strategies are not guaranteed to meet their objectives and are subject to loss. Investing in the fund is not suitable for all investors. Investors should consult their investment professional before making an investment decision and evaluate their ability to invest for the long term. Because of the nature of the fund's investments, the results of the fund's operations may be volatile. Accordingly, investors should understand that past performance is not indicative of future results.

- Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries.

- Illiquid assets are more difficult to sell and may become impossible to sell in volatile market conditions. Reduced liquidity may have an adverse impact on the market price of such holdings, and the fund may be unable to sell such holdings when necessary to meet its liquidity needs or to try to limit losses, or may be forced to sell at a loss. Illiquid assets are also generally difficult to value because they rarely have readily available market quotations. Such securities require fair value pricing, which is based on subjective judgments and may differ materially from the value that would be realized if the security were to be sold. Situations involving uncertainties as to valuation of assets held by the fund could have an adverse effect on the returns of the fund.

- The fund is a non-diversified fund that has the ability to invest a larger percentage of assets in the securities of a smaller number of issuers than a diversified fund. As a result, poor results by a single issuer could adversely affect fund results more than if the fund were invested in a larger number of issuers.

 

For Public-Private Credit+ Funds:

- Bond investments may be worth more or less than the original cost when redeemed. High‐yield, lower‐rated, securities involve greater risk than higher‐rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

- The funds may invest in structured products, which generally entail risks associated with derivative instruments and bear risks of the underlying investments, index or reference obligation. These securities include asset-based finance securities, mortgage-related assets and other asset-backed instruments, which may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market's perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations.

- While not directly correlated to changes in interest rates, the values of inflation-linked bonds generally fluctuate in response to changes in real interest rates and may experience greater losses than other debt securities with similar durations. The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.

- The fund invests in private, illiquid credit securities, consisting primarily of loans and asset-backed finance securities. The fund may invest in or originate senior loans, which hold the most senior position in a business's capital structure. Some senior loans lack an active trading market and are subject to resale restrictions, leading to potential illiquidity. The fund may need to sell other investments or borrow to meet obligations. The funds may also invest in mezzanine debt, which is generally unsecured and subordinated, carrying higher credit and liquidity risk than investment-grade corporate obligations. Default rates for mezzanine debt have historically been higher than for investment-grade securities. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy.

 

For Public-Private Equity+ Funds:

- The fund also intends to concentrate in the financial services group of industries, and to invest at least 80% of its assets in securities issued by companies based in the United States.

- K-PEC and co-investment risks: The fund's investments in KKR Private Equity Conglomerate LLC (“K-PEC”) and co-investments alongside K-PEC or one or more other KKR vehicles that pursue private equity strategies entail additional risks. Private equity investments are typically illiquid, speculative, and difficult to value, often requiring multi-year holding periods with returns generally realized only upon sale or refinancing of a portfolio company. These investments depend on access to financing, and market disruptions or increased competition may limit opportunities and affect performance. The fund's significant investment in K-PEC creates concentration risk and a decline in K-PEC's value could materially impact the fund's returns. Co‑investment opportunities are competitive and limited and there is no assurance the fund will receive allocations or comparable terms and will generally have less information than for public companies. Through its investments in K-PEC or other KKR Vehicles and co-investments, the fund may have exposure to portfolio companies with limited operating histories, evolving markets, unproven technologies, and inexperienced management, which may require significant capital and create heightened vulnerability to downturns. Most holdings are illiquid, subject to resale restrictions and may require consents or be sold at a discount. Costs associated with investments in private equity are generally greater than those of investments in other asset classes. In addition to bearing their portion of the fund's fees and expenses, shareholders in the fund will indirectly bear a portion of the asset-based fees, incentive fees and other expenses incurred by the fund as an investor in K-PEC or other KKR Vehicles and in co-investments. Incentive fees are paid to KKR when the fund's investments in K-PEC or other KKR Vehicles and/or co-investments deliver returns in excess of a specified hurdle; when paid, these fees reduce the net realized returns of such investments.

This material does not constitute legal or tax advice. Investors should consult with their legal or tax advisors.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.
Capital Group and Kohlberg Kravis Roberts & Co. L.P. (“KKR”) are not affiliated. The two firms maintain an exclusive partnership to deliver public-private investment solutions to investors. KKR serves as the sub-adviser of Capital Group KKR Core Plus+ and Capital Group KKR Multi-Sector+ with respect to the management of each fund's private credit assets. KKR is not a sponsor, promoter, investment adviser, sub-adviser, underwriter or affiliate of Capital Group KKR U.S. Equity+.
All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.
Use of this website is intended for U.S. residents only. Use of this website and materials is also subject to approval by your home office.
Capital Client Group, Inc.
This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.