What is private equity, really?

TRNTO x Nicola Wealth

For many investors, private equity can be intimidating. Beyond the learning curve associated with the market, this attractive investment can present significant barriers to entry for individual investors

The lack of transparency in disclosure requirements, restricted access to enough quality opportunities to create a diversified portfolio, high minimums, and fees, among other drawbacks, deter most investors from participating in this asset class that otherwise may be a standout contributor to an individual’s well-balanced portfolio. Meanwhile, institutional investors continue to increase their allocation to this attractive asset class, yet it continues to be out of reach for most individual investors.

THE CONVENTIONAL APPROACH TO PRIVATE EQUITY

Like publicly traded equities, private equity denotes an ownership stake in a company that’s meant to generate a return in the form of capital gains and possibly dividends. We say private because the companies involved do not list their shares on a stock exchange and are not required to disclose their financial statements to the public. They generally keep their affairs private.

At the institutional level, most private equity investments are made through funds, managed by specialized asset managers, known as sponsors or general partners (GPs). These funds have a finite life, often ten to fourteen years, during which the manager buys, manages, and sells their investments in private businesses. GPs raise money from other investors, known as limited partners (LPs), to buy these private companies, they make changes to the businesses aimed at increasing profitability, and then they sell them at a higher price to another buyer or into the public markets. The whole process takes anywhere from five to 12 years.

Private equity is considered its own asset class because there are important differences in the way it behaves compared to the stock market. An investment’s value does not oscillate with every quarterly earnings report or shift in investor sentiment. Not only does it tend to generate higher returns than other major asset classes, but the lack of significant valuation swings results in consistency which helps reduce overall portfolio risk.

What stops more investors in participating in private equity are the high barriers to entry. Fund managers typically demand large minimum investments, often $10-million. Beyond that the management fees they charge are substantially higher than those of public equity and fixed income managers on the grounds that they help run the companies they buy. These management fees are charged on committed capital, not how much is put to work, which causes the effective management fee to be markedly higher than what is posted. On a $10-million commitment, and a typical 2% management fee, the investor is paying $200k/year in management fees from day one, regardless of how much is actually deployed into investments. Also notable are the drawbacks related to private equity funds’ lack of liquidity—you are not be able to withdraw funds in an emergency.

HOW NICOLA DOES PRIVATE EQUITY DIFFERENTLY

Uniquely in Canada’s investment management industry, Nicola Wealth attempts to solve, or at least ameliorate, every one of these disadvantages for its clients. We address concentration risk by working with multiple fund managers, spreading the risk across many investments, and diversifying across sectors, from space travel to refrigeration, company sizes and and geographies. By contrast, a typical private equity fund might invest in just ten companies that may share many characteristics.

Importantly, we also structure the Nicola Private Equity Limited Partnership to be “evergreen” in that it participates in a rotating series of closed-end funds and direct co-investments at different points in their life cycles at any one time. This way, investors can invest at a time of their choosing. And where single private equity funds may take years to put all your capital to work, Nicola Wealth clients can rest assured their contributions will get invested almost im- mediately in a well diversified manner.

The evergreen format has another key advantage: liquidity. Where traditional private equity offerings do not offer any redemption options – liquidity happens only when the underlying businesses are sold or pay a dividend —Nicola Wealth offers clients the ability to sell their position for fair value when in a pinch, for whatever reason.

With respect to management fees, Nicola Wealth keeps fees in check by focusing on opportunities where if there is a management fee, its only charged on invested capital, not committed capital that is waiting to be invested. “We invest in funds that are managed by sponsors such as Northern Private Capital, Regimen Partners, Harbourvest Partners and Partners Group,” says Kazuki Nohdomi, Portfolio Manager at Nicola Wealth. “In addition to these funds, we also participate in co-investments where we invest directly into businesses alongside a GP, often on a no-management fee, no-performance fee basis.” The result is that the fees passed on to clients invested in the Nicola Private Equity LP are significantly cheaper than the old two-and-20, and we continue to look for ways to trim those charges.

HIGHER PERFORMANCE, LOWER RISK

Remarkably, all these unique advantages do not sacrifice anything in the way of returns, judging by the Nicola Private Equity LP’s performance since its launch in 2012. As of June 30, 2021, over the past three and five years, it has gained an average of 13.7% and 11.9% per year, outstripping the Canadian stock market by 2.9% and 1.1% percentage points on average per year, respectively.

But it’s not an either/or. Private equity is meant to complement, not replace, publicly traded stocks in your portfolio. Having both asset classes provide exposure to smaller, high-returning, less liquid private companies alongside larger, readily tradeable public ones. Including private equity in your portfolio should not only boost your overall returns but also help reduce the risk of capital losses and preserve your wealth in adverse market conditions.

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