Does private equity offer schemes good value?

While top private equity funds have outperformed public equity markets by a sizeable margin, and therefore represented ‘good value’, pension schemes’ experiences of the asset class have been varied.

Add to that the fees that are paid along the way, and the question of whether private equity represents good value or not becomes more difficult to answer.

In its simplest form, we can think of private equity as providing capital to companies that are not listed, to create value either through enhanced expansion or growth, and/or financial or operational restructuring.

The benefit for pension schemes comes from a number of areas: firstly from diversity in exposure to different types of businesses compared with quoted equity portfolios.

Good governance helps schemes to access genuine diversity, rather than simply leveraged equity exposure to equity risk

Secondly, as an illiquid investment, investors can expect to earn an illiquidity premium over investment in public equities. This feels attractive for an investment of 10 to 12 years, when compared with public equities, which most pension funds hold for about five years but do not earn an illiquidity premium from.

Finally, there is an expectation of the general partner of a private equity fund to add value through their own expertise – this is, perhaps, the area that is most difficult to evaluate, and likely to have contributed meaningfully to the large divergence in performance between different funds.

How do private equity funds generate value?

It could be through improved incentives or governance of portfolio companies, their approach in facilitating a high value exit or sale, additional acquisitions and restructuring to increase revenues and/or reduce costs; the list goes on.

With several different approaches to generating value from portfolio companies and a wide range of industries, private equity is a rather heterogeneous asset class.

Obtaining good value from private equity requires a lot of consideration on the design of the programme; this influences the selection of funds, which ultimately drives the returns.

And this is exactly how pension schemes have managed to achieve good value. Key clarity on the purpose, process and philosophy for investing in private equity has been critical to help trustees focus on what types of funds to invest in.

Good governance helps schemes to access genuine diversity, rather than simply leveraged equity exposure to equity risk.

As well as having strong governance to identify the right exposure, consideration of the terms of investment influences value creation.

We all know that fee structures can make a meaningful difference to returns, and a few studies have shown that this alone can make the difference in whether private equity adds value or not relative to investment in public equities.

Private equity fee structures can be complex; paying attention to the details, and partnering with providers who are able to negotiate better fees and terms can generate significant value for pension schemes.

With a diverse asset class such as private equity, governance can make a real difference. Spending time to determine the right questions to ask of private equity providers is more likely to help construct an appropriate portfolio and generate value.

There is evidence that private equity can add value relative to public equities, but it depends a lot on the structure of the programme, choice of funds and associated fees and costs. As in most asset classes where active management is used, good governance is critical to success.

Rikhav Shah is senior manager at consultancy EY