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Understanding the Characteristics of Private Equity Investments

As discussed in our previous post, the private equity (PE) industry is facing challenges in the current inflationary environment of rising interest rates. However, historically, PE has also delivered stronger returns relative to public markets, especially after economic recessions. We’ve suggested some factors to consider before making long-term investments during economic uncertainty, which could be crucial when volatility is high now. Economic uncertainty may erode portfolio returns, but it presents new opportunities for investments at cheaper prices. Taking a step back, it is thus important to understand the fundamentals of this asset class. In this article, we delve deeper into some of the key characteristics – barriers to entry, expected returns, investment horizon as well as risks involved when investing.

Investments in PE and VC require a large amount of capital, causing barriers to invest in the asset class to be relatively high. PE/VC firms often target investors who are ready to commit a certain amount of capital, usually with a minimum check size of $250,000, depending on the stage of investments. For a longer holding period, the check size could be smaller with a higher targeted return. This also means that your capital would be locked up for a longer duration. It is unusual for the mass market to present such characteristics as investors would generally need to have enough liquidity, as well as the relevant experience in evaluating private companies, to feel comfortable allocating their capital in PE/VC.

Thus, investing in PE and VC comes with significant risks – mainly liquidity risk and market risk. Investments are usually illiquid as it takes time for a company to produce results, resulting in longer holding period for investors. The investments are also heavily dependent on the performance of the underlying companies. Various factors such as an incompetent leadership team, competitive product space and technology being obsolete could be reasons for the downfall of a company.

Along with the risks associated, expected returns in this asset class tend to be higher than those for public markets. Target companies of PE investors are usually high growth with significant potential yet to be realised. The investment amount would allow these companies to improve their operations and increase their profitability, thereby reaching a higher valuation at exit. The long-term focus allows the firms to constantly improve and make strategic decisions to create additional value. There is also a certain level of control over the companies, which may not be feasible in public companies. The management team could work closely with investors to ensure that the goals are aligned, maximising the potential value of the investments.

Investors could also have access to PE companies through private equity funds where investments are pooled together before the funds are deployed. Private equity funds are long-term focused as well, with the investment period spanning across the first five years, along with holding period before the fund exits the investment through either an IPO or trade sale before distributing the returns.

Thus, it is crucial for investors to conduct extensive research and analysis before injecting capital. By understanding the risks and return profile of an investment, as well as diligent selection of sectors and companies, investors will be able to achieve attractive investment opportunities. In the next article, we will provide deeper insights into the creation of an investment strategy at Kairos Capital Group, along with the due diligence process and efforts we believe in.

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