Invest in future unicorns

Private equity funds have a term of around 12 to 16 years. At the beginning of the term, investors commit a certain amount of capital to a target fund which the fund manager then invests in companies. The committed capital gradually falls due as the manager identifies companies for acquisition. Typically, the capital is invested in the first five years. Next comes the selling phase, during which the fund manager tries to sell the shares at a profit. The sale of the companies entails a distribution to the investors. At the end of the term, the fund is dissolved.

Over the long term, private equity has the most attractive risk-return profile of any asset class. Among other factors, this is due to the so-called liquidity premium associated with private equity investments, which investors expect as compensation for their limited liquidity. In addition to the potential returns, private equity investments also improve diversification of the overall portfolio. After all, they allow investors to tap into the vast but difficult-to-access market of privately held companies.

In return for the attractive risk-return profile, investors accept restricted liquidity as their invested capital will be tied up for the long term. What’s more, the costs are significantly higher than in the case of traditional investments. Pension funds must diligently analyse their future obligations and how they will provide the necessary liquidity. With around 5,900 private equity managers worldwide launching around 1,500 new private equity funds every year, the investment universe in the private equity market is very broad, making market evaluation a complex and time-consuming business.

To build a private equity portfolio, investors need time and a strategy that defines how they will reach and maintain their target quota. For diversification purposes, investors should invest in a number of new private equity funds each year. Where investors follow a systematic investment approach, the restriction on their liquidity is only temporary, since private equity portfolios should refinance themselves after about five years of continuous portfolio building. In such cases, the distributions are sufficient to finance the capital calls for new investments. Investors may reasonably expect that their private equity portfolio will be repaid on a net basis after about eight to ten years and that the quota will be self-sustaining.

During the build-up of a private equity allocation, investors are responsible for managing the committed but uncalled capital themselves – for example, in equities or money market investments or in liquid form. The choice of investment depends on the investor’s risk appetite and preference. For the most part, it makes sense for investors to hold the portion of the capital that can be called up in the next few years in low-risk investments (money market investments or short-term government bonds).

Stage 1: During the fundraising phase, the private equity fund manager obtains investment commitments from investors. Usually, fund managers acquire holdings themselves as a means of sharing the same interests as the investors.

Stage 2: At the beginning of the investment phase, which usually lasts five years, the fund acquires company shares and progressively calls up the investors’ capital. Depending on the transaction structure, the fund leverages a part of the purchases with acquisition financing.

Stage 3: The fund manager applies various strategies to increase the value of the company. Among such strategies are, for instance, expansion or internationalisation of business activities, new product generations or the optimisation of business processes and costs.

Stage 4: During the exit phase, the fund manager either sells the investments to strategic investors (trade sale) or passes them on to financial investors (secondary buy-out). In some cases, they also consider IPOs alongside simultaneous sales (dual track).