Private Equity Comparison

Investments vary widely based on the perceived levels of risk versus reward and any discussion of various investment instruments revolve around this relationship. Investment can take several different forms including private equity, stocks, mutual funds, hedge funds, bonds and debt.

As an investment strategy, it is important to allocate available funds across the risk spectrum. This will allow for a medium level of overall risk and closer monitoring of the higher end of the spectrum. While private equity is perceived as having the greatest risk, this may not always be true. Since private equity is the most flexible, it can be structured in many different forms including being secured by assets not fully secured by debt.

This is an advantage private equity can have compared to stocks or mutual funds which are unsecured investments in publicly traded companies. Private equity may also have this advantage against other unsecured instruments including bonds or hedge funds. Hedge funds have no security unless an investor hedges both sides of an anticipated future result in what is called a ‘straddle.’

By the same token, private equity can be totally unsecured similar to stocks or mutual funds. Typically, the unsecured investments create an expectation of higher return. This is demonstrated by debt on the low end which usually has a fixed rate of return associated with repayment of the debt. Bonds on the other hand, are a negotiable debt instrument that is usually unsecured but must be repaid by the company before investment instruments. As a result, on average, bonds will generate a return greater than debt but less than investments like private equity, stocks, or mutual funds.

Another comparison is the relationship between macro and micro economics. All investment and debt instruments are affected by macroeconomics but some instruments, such as private equity, stocks, bonds and debt are primarily geared toward a specific company and its particular economic health.

The wide variety of mutual funds and hedge funds can act like a rheostat between micro and macro depending on the size of the pool of companies in the fund. The expected return is usually an inverse relationship to the number of individual entities in the fund and the larger the fund, the lower the expected return.

The level of participation relative to the total investment plays a role in expected return. Most of the time private equity plays a major role in the financing of an entity at the time the investment is made. This high level of investment usually induces a structured expectation of high return along with a profitable exit strategy such as an IPO within a specified time frame. This particular scenario is unique to private equity.

Calculating the exposure to loss will be a factor in determining the expected return on investment by the different instruments. Secured debt can ultimately sell the assets to minimize losses.

Positions in stocks and mutual funds can incur a total loss but are completely negotiable in the marketplace, allowing the investor to reduce the loss by selling at a lower price. Hedge funds typically limit the loss to that incurred within a certain time frame but they can still be substantial.

Losses resulting from private equity investments will depend on the structure of the investment. It can be anything from a total loss to whatever recovery is possible through the sale of assets.

Finally, private equity investment almost always means significantly greater participation by the investing firm than expected in other types of investments. Private equity firms will be intimately involved in strategic and tactical operational decisions in an effort to protect the investment and propel it toward the goals that have been established.