Private equity performance drivers
Summary
Written transcription
Louis Flamand: Why has private equity historically outperformed most other asset classes? It's a legitimate question for any well-informed investor. And with good reason. The spectrum of investment opportunities is vast. Between equities, bonds, real estate and alternative investments. But private equity stands out in many ways. Today, I'm going to show you why this asset class has become a must-have for institutional investors, and why it should be considered in any diversified portfolio. Firstly, private equity is not only a historically outperforming asset class, but also one with lower volatility. Private equity has a proven track record of outperforming listed markets by 600 to 700 basis points per year, which is almost double the annual return. While listed markets return an average of 8% per annum, private equity returns around 14.5% net per annum. But performance isn't just about returns. Private equity is also characterized by low volatility, thanks to long-term investment horizons of 5 to 10 years, and strategies that are sheltered from the immediate fluctuations of public markets. Clearly, where listed markets fluctuate according to economic or political news, private equity is part of a more stable, structural dynamic. Institutional investors are not mistaken. They regard private equity as a cornerstone of their portfolios, not only for its performance, but also for the resilience it brings in times of economic crisis.
Louis Flamand: Secondly, the investment universe of private equity is infinitely broader than that of listed markets. One figure speaks for itself: 95% of the world's companies generating sales of over $100 million are unlisted. This means that there are 20 times more nuggets to be discovered in the unlisted sector than in the public markets. What's more, the universe of listed companies has shrunk considerably. In the United States, for example, the number of listed companies has been halved in 20 years, from 8,000 to around 4,000. Meanwhile, the number of unlisted companies has continued to rise sharply, further expanding the scope of opportunities for private equity investors. Unlike public markets, which offer a limited and increasingly concentrated hunting ground, private equity provides access to the real economy with unrivalled diversification and value creation.
Louis Flamand: This outperformance is based on systematic levers that funds use repeatedly to generate this outperformance versus listed markets. I'd really like to detail these levers, because understanding them is fundamental to understanding why private equity has outperformed over the past 20 years. The first lever is the alignment of interests. When a private equity fund buys a company, it does two fundamental things: first, it asks the management to invest capital alongside it.
Louis Flamand: This means that the managers will buy shares in the new company at the same price per share as the fund. When it's a primary LBO, in other words, we're talking to managers who used to be employees, who are going to invest in the capital for the first time, and who don't have much capital of their own. Typically, the funds will ask the CEO to invest 12 to 18 months' salary, the Comex executives to invest 6 to 12 months' salary and the third circle to invest 6 months' salary. If it's a secondary or tertiary LBO, the fund will ask the management team to reinvest at least a third of the gain it made on the previous transaction, net of tax. This alignment of interests enables the fund to: (1) ensure that management does not oversell its business plan in order to extract the best possible price for the selling owners. (2) that if one day the company doesn't do as well as expected, the managers will stay on board and do everything they can to recover their stake, or even earn a little money on their capital. And finally (3), that if, on the other hand, all goes well, the investing managers will be highly motivated to get the best price when their partner funds exit.
Louis Flamand: Secondly, the private equity fund will offer the management, or rather sell it, options at a market price which will enable the management to recoup between 15 and 20% of the capital gain on the transaction.
Louis Flamand: The day management moves from employee to shareholder, its behavior changes radically. They are much more focused, motivated by cost savings. Cash and WCR management, strategies for conquering new markets and new products. Finally, I'd like to add that private equity managers are themselves obliged to invest significantly in their funds if they want to raise money. So in the private equity industry, everyone has to invest to create value, which ensures a much stronger alignment of interests than in listed markets, where managers typically don't need to invest to get stock options. The second lever is tight governance. The private equity fund knows the company's business plan in detail and monitors all its key performance indicators. It interacts frequently with the management team, with weekly meetings to discuss strategic issues such as recruitment, acquisitions and markets. And board meetings to review the progress of leading operational indicators and compliance with business plan milestones, and the implementation of action plans in the event of delays. The fund also invites a whole range of experts to sit on its Board of Directors. Independent experts, professionals from the private equity ecosystem, former executives or specialists who provide advice on specific subjects: marketing, technology, industry.
Louis Flamand: In-house operational experts, members of the fund's operational team with proven expertise in similar situations. Able to share playbooks or best practices based on successful past experiences. A third lever for value creation is the implementation of buy-and-build strategies, which consist in consolidating a particular sector or sub-sector. This strategy involves first buying an industry leader at a reasonable price, e.g. 12x EBITDA, to act as a platform which will then acquire smaller competitors at a lower cost, e.g. 8x EBITDA because they lack critical mass. This strategy has mechanical virtues. Firstly, it boosts multiples. Small competitors purchased at 8x EBITDA are immediately valued at 12x when integrated into the platform, generating an instant gain in value. Secondly, operational synergies: the integration of small players into the platform generates savings through the pooling of resources: human, technological, real estate, which improves EBITDA. Thirdly, the creation of a strategic platform: once consolidated, the platform benefits from superior strategic value, thanks to its ability to grow faster, be more profitable, diversify its customer base and easily integrate new regional acquisitions. Ultimately, the consolidated platform sees its valuation increase. For example, from 12x to 15x EBITDA. This strategy thus transforms a fragmented whole into a coherent, high-performance industrial machine, capable of generating a strong increase in value.
Louis Flamand: A fourth mechanical lever, key to private equity, is management remuneration systems and the relationship with time. Partners in LBO funds are assessed on their ability to achieve the objectives set out in a business plan over a period of 5 to 7 years. An annual performance of less than 8% on committed capital does not entitle them to a performance fee. Carried interest, their main financial incentive. This pushes managers to aim for high returns over the long term, which is perceived as a virtuous incentive. The aim is usually to generate a net annual return in excess of 15%, aligning the efforts of LBO managers and funds towards sustainable value creation. Listed funds, on the other hand, are judged on their quarterly performance or underperformance relative to a market benchmark. For example, a return of 5% against a market benchmark of 3% can guarantee a bonus. Unlike private equity, they operate over short time horizons, influenced by the vagaries of the market. Last but not least, private equity operates on a long-term basis. Funds remain invested in a company for 4 to 7 years. In contrast, the average holding period on listed markets is five months, a ratio of 1 to 12. This long holding period enables private equity funds to align themselves with business plans and contribute to the real economy, unlike listed funds, which are more responsive to short-term fluctuations.
Louis Flamand: A fifth lever for value creation is the patient and proactive selection of champions. This proactive and meticulous selection of targets follows several stages: (1) Identification of sectors showing positive structural growth. (2) The identification of companies in these sectors with a sustainable competitive advantage capable of maintaining their dominant position. (3) Early involvement: the funds establish a dialogue with the target companies well before they are put up for sale. This enables them to understand the company's strategy, ambitions and potential. This preparation can take months, even years, and gives access to privileged information not available to competitors. (4) In-depth analysis: even before the sale process, the fund can carry out strategic, financial and accounting due diligence to assess the company's commercial potential and performance. This is how the best funds invest. Again, this gives them several advantages over listed fund managers: (1) Exposure to better growth. Private equity funds invest in sector leaders, which is not systematically the case with the portfolios of listed fund managers. These sector leaders often enjoy higher structural growth than listed companies, whose growth is often aligned with GDP growth. Better growth translates into higher asset valuations.
Louis Flamand: Secondly, access to exclusive information. Private equity funds have access to detailed strategic, operational and financial data obtained directly from target companies. This level of information is inaccessible to listed fund managers due to the strict rules of public markets. This quality of information enables funds to better understand a company's potential and optimize their investments. A sixth and final important lever for value creation is the proactive and strategic preparation of companies for optimal resale. The process of transforming and preparing targets revolves around 3 key stages. (1) A clear vision for the acquisition: the private equity fund buys a company having drawn up a precise business plan in collaboration with the management team. The aim is to identify how the company can be transformed over a 5-7 year period to maximize its value. Secondly, an industrial transformation. During the holding period, the fund works actively with the management team to improve the company's operational and industrial performance. This transformation ambition adapts to the realities on the ground, while remaining focused on long-term objectives. Thirdly, preparation for resale. From the moment of acquisition, the fund considers the best exit strategy by identifying potential buyers, ideally industrial buyers willing to pay a strategic premium. The last three years of ownership are spent interacting with these potential buyers to test their interest and prepare the company to meet their expectations.
Louis Flamand: Why does this approach outperform listed markets? Because (1) thanks to proactive planning, unlike listed fund managers, private equity funds actively prepare their targets to be attractive to buyers, thus maximizing their value. (2) Targeted transformation: they have a direct influence on the management of the company's strategy, optimizing its performance and presentation for a successful sale. (3) Optimized exit: the resale is not left to chance. It is planned and worked on over several years, enabling the funds to capture a valuation premium impossible for a passive manager to achieve. It's really important to understand that these six levers of value creation are exclusive to private equity. Listed fund managers don't have access to the information, management and governance needed to implement the strategies I've just described. These strategies are only available to investors who have the long-term, proactive governance of private equity.
Louis Flamand: Institutional investors' historic confidence in this asset class is further proof of private equity's outperformance. Private equity has been a strong conviction of institutional investors for 60 years in the United States, 40 years in Europe and 20 years in Asia. Today, institutional investors allocate an average of 20% of their portfolios to this asset class, testifying to their total confidence.
Louis Flamand: A few figures to gauge the scale of the phenomenon. The size of institutional private equity has grown from $1,000 billion in 2004 to $5,500 billion in 2024, a 5.5-fold increase in 20 years. Each year, institutional investors inject between $500 and $1,000 billion into the industry, consolidating its central role in their strategy. Admittedly, private equity is less liquid than listed markets, but this liquidity is the quid pro quo for sustainable outperformance, as it is based on business plan horizons of 5 to 7 years. This is a characteristic that private investors already accept on a massive scale in real estate, an asset class that no longer outperforms today. Private equity, on the other hand, offers far superior performance. In conclusion, private equity is an essential pillar of a diversified portfolio. Private equity combines superior historical performance, low volatility, a vast investment universe and unique value-creation levers. It is an essential asset class for any strategic allocation. With Altaroc, you benefit from an optimized and rigorous approach, selection of the best managers, alignment of interests with our founders and unique human and technological support. Maurice Tchenio and Frédéric Stolar, our co-founders, invest 33 million euros of their own capital in our Vintage funds every year, guaranteeing our unfailing commitment.
Louis Flamand: Investing in private equity with Altaroc means gaining access to an asset class that outperforms listed markets while actively participating in the real economy.
