The Truth Revealed: Governance structures in private equity may contribute to the asset class’ outperformance
Once considered speculative, private markets continue to evolve, especially as the structural hurdles for high-net-worth (HNW) investors have come down. Still, no matter the level of expertise or market environment, investors and advisors who understand this segment of the market are well-positioned to make informed and comprehensive decisions about their portfolios.
This Truth Revealeds series explores private market investing with three objectives in mind:
- To dispel some of the incorrect notions about private markets;
- To help investors and advisors better understand private markets’ potential to outperform public markets;
- To assist investors and advisors as they consider how private markets investing may align with their investment objectives
What you should know
- A key reason private equity tends to perform better than public equity may be due to more robust governance structures.
- In the private equity world, key stakeholders are laser-focused on seeing the portfolio company do well – rather than focusing more narrowly on stock price.
- Data shows that the private capital markets are comprised of a high volume and variety of companies which generally have strong growth, governance models and use of leverage.
Private equity overview
There’s no denying that private markets are often misunderstood. Private equity refers to an investment model where institutional investors, ultra-high-net-worth individuals, and other accredited investors pool their money to invest in privately held companies or acquire controlling stakes in public companies. Private equity firms are responsible for managing these investments on behalf of their investors.
The Composition of the Private Markets
Private markets comprise private equity, private credit, and real assets. Because private equity – which includes buyout, venture capital and growth equity strategies – tends to represent the largest segment of private markets, the terms “private markets” and “private equity” are sometimes used interchangeably.
Over the years, private equity was the exclusive province of institutional and accredited investors, and only recently are investors and advisors starting to better understand private equity. Below we touch upon some facts about private equity that you should know.
Private equity misconception: it’s all about the leverage
With the mounting data supporting the cause for private equity, there’s been an increase in investor interest. Notwithstanding the evidence supporting the argument that private equity has a strong risk/return profile, there’s still a notion that private equity is more about leverage, engineering financial returns or intricate corporate transactions.
Some people look at private equity and assume it’s a game of replacing management teams, cutting costs, and then selling the company at a price that doesn’t reflect its intrinsic value. In this scenario, it seems like everyone loses except the private equity firms.
This type of scenario makes for a riveting story, but it doesn’t reflect reality – especially today. The private markets have evolved over the past decades, and one key reason private equity does better than public equity is because of different governance structures.
Private Equity Governance: A long-term, active management philosophy
Establishing governance structures includes everything from creating strong boards of directors with clearly expressed roles and responsibilities to hiring the right management team and creating the right incentive structure.
In private equity, when a fund buys a company, they control both the company and the board. This makes it easier for management to create a capital structure that gives companies the flexibility to adjust - no matter the market conditions. This is especially true for buyout deals, where private equity firms take a controlling interest in a private company.
Private equity firms typically have a management team and a board of directors that oversee the portfolio company's operations and investments. The board of directors usually includes both internal and external members, including representatives from the private equity firm, independent directors, and possibly representatives from the portfolio company.
Private equity firms have a fiduciary responsibility to their investors, meaning they are legally obligated to act in their investors' best interests. This includes making investment decisions that they believe will generate a positive return, as well as ensuring that the portfolio companies operate ethically and in compliance with laws and regulations.
To ensure good governance, private equity firms often implement various measures, such as conducting due diligence on potential investments, implementing strong risk management policies and procedures, and monitoring the performance of portfolio companies. Additionally, private equity firms may engage with management teams to improve governance practices and implement best practices for financial reporting, stakeholder engagement, and the like.
In short, private equity firms are typically long-term investors as well as managers who are actively involved in the day-to-day operations of the business. As opposed to stock price, there’s a tendency in private equity to focus on operational efficiency and growth. Because private equity firms typically have huge stakes in the company, they are all motivated and aligned for one very specific thing: improving the company.
How does this compare to public companies? Oftentimes public companies’ management teams are less involved in the business’ operations to the same extent as they are with private companies. It’s also common to see public company managers compensated based on cash or rapid stock price appreciation, translating to a substantial payout for options holders. However, this doesn’t mean that the actual company is performing well.
When it comes to investing, the past is no guarantee of the future, but the data is compelling. By most measures, in the private equity world, there are more companies, stronger growth, better governance models, and overall better use of leverage. If you’re interested in learning more about how the private markets universe is less concentrated and larger today than any other time in history, read fact one of our Truths Revealed series.
Strategy Definitions
Credit – This strategy focuses on providing debt capital.
Infrastructure – An investment strategy that invests in physical systems involved in the distribution of people, goods, and resources.
Mega/Large Buyout – Any buyout fund larger than a certain fund size that depends on the vintage year.
Natural Resources – An investment strategy that invests in companies involved in the extraction, refinement, or distribution of natural resources.
Real Estate – Any closed-end fund that primarily invests in non-core real estate, excluding separate accounts and joint ventures.
SMID Buyout – Any buyout fund smaller than a certain fund size, dependent on vintage year.
VC/Growth – Includes all funds with a strategy of venture capital or growth equity.
This presentation has been prepared solely for informational purposes and contains confidential and proprietary information, the disclosure of which could be harmful to Hamilton Lane. Accordingly, the recipients of this presentation are requested to maintain the confidentiality of the information contained herein. This presentation may not be copied or distributed, in whole or in part, without the prior written consent of Hamilton Lane.
The information contained in this presentation may include forward-looking statements regarding returns, performance, opinions, the fund presented or its portfolio companies, or other events contained herein. Forward-looking statements include a number of risks, uncertainties and other factors beyond our control, or the control of the fund or the portfolio companies, which may result in material differences in actual results, performance or other expectations. The opinions, estimates and analyses reflect our current judgment, which may change in the future.
All opinions, estimates and forecasts of future performance or other events contained herein are based on information available to Hamilton Lane as of the date of this presentation and are subject to change. Past performance of the investments described herein is not indicative of future results. In addition, nothing contained herein shall be deemed to be a prediction of future performance. The information included in this presentation has not been reviewed or audited by independent public accountants. Certain information included herein has been obtained from sources that Hamilton Lane believes to be reliable, but the accuracy of such information cannot be guaranteed.
This presentation is not an offer to sell, or a solicitation of any offer to buy, any security or to enter into any agreement with Hamilton Lane or any of its affiliates. Any such offering will be made only at your request. We do not intend that any public offering will be made by us at any time with respect to any potential transaction discussed in this presentation. Any offering or potential transaction will be made pursuant to separate documentation negotiated between us, which will supersede entirely the information contained herein.
Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request.
The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12-year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return.
Hamilton Lane (Germany) GmbH is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (Germany) GmbH is authorised and regulated by the Federal Financial Supervisory Authority (BaFin). In the European Economic Area this communication is directed solely at persons who would be classified as professional investors within the meaning of Directive 2011/61/EU (AIFMD). Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.
Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (UK) Limited is authorised and regulated by the Financial Conduct Authority (FCA). In the United Kingdom this communication is directed solely at persons who would be classified as a professional client or eligible counterparty under the FCA Handbook of Rules and Guidance. Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.
Hamilton Lane Advisors, L.L.C. is exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 in respect of the financial services by operation of ASIC Class Order 03/1100: U.S. SEC regulated financial service providers. Hamilton Lane Advisors, L.L.C. is regulated by the SEC under U.S. laws, which differ from Australian laws. The PDS and target market determination can be obtained by calling 02 9293 7950 or visiting our website www.hamiltonlane.com.au.
Any tables, graphs or charts relating to past performance included in this presentation are intended only to illustrate the performance of the indices, composites, specific accounts or funds referred to for the historical periods shown. Such tables, graphs and charts are not intended to predict future performance and should not be used as the basis for an investment decision.
The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice, or investment recommendations. You should consult your accounting, legal, tax or other advisors about the matters discussed herein.
The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g. cash flows and valuations), and have not been prepared, reviewed or approved by the general partners.
As of May 31, 2023
