How to invest in private companies that are off limits to you

Private equity for everyone

(Aaron Harris/Reuters)

(Aaron Harris/Reuters)

Investors reacted badly to the news that Prem Watsa’s deal to take over BlackBerry fell apart a few weeks ago, sending the cellphone maker’s stock down 18%. Many felt BlackBerry would be better off as a private company. That’s when the story usually ends for retail investors: Most private companies are just that—private—and off limits to all but the most well-heeled investors.

private equityBut there is a way for ordinary investors to get into the private equity game, as Watsa’s Fairfax Financial demonstrated in the BlackBerry saga. They can buy the stock of private equity players that are themselves publicly traded, such as Fairfax, Onex Corp., the various Brookfield entities and even Warren Buffett’s legendary Berkshire Hathaway. Instead of making and selling goods, these companies buy other firms or infrastructure assets and either hold them long term or turn them around for an eventual sale. “They invest in a very concentrated portfolio of companies that happen to not be publicly traded,” says Dan Dupont, a fund manager with Fidelity investments. “It’s a way for people to get into this market.”

New research suggests there are good reasons for getting exposure to private equity, too. A study out of the Stern School of Business and Harvard University found that private firms grow faster than public ones. The average investment rate among private companies is nearly twice as high as public firms—6.8% compared to 3.7% of total assets per year. Private firms’ investment decisions are also more than four times more responsive to changes in opportunities than public companies.

There are three reasons why private businesses grow faster, the authors write. First, public companies have an “agency problem,” the inherent conflict of interest between executives wanting to create wealth for themselves and doing what’s best for shareholders. And because people can sell stock at any sign of trouble, this “weakens incentives for effective corporate governance.” The second issue is what the academics call the “quiet life”; managers of public companies sometimes avoid making investment decisions because they don’t want to rock the boat. The third concern is “short-termism” or the focus on short-term profits.

hotstocksIt’s this last point that has the biggest effect on private versus public company returns, says Tim McPeak, director of financial institutions at Sageworks, a company that studies financial information of privately held companies. “Publicly traded companies have a lot of people to answer to,” he says. “Private businesses aren’t under the same quarterly scrutiny, so the pressure’s off, and they can make investment decisions with less layers and less examination.”

But do the benefits of owning a private company get passed on to retail investors who own publicly listed private equity businesses? They do, in the form of dividends, capital appreciation and share buybacks, says Bob Stammers, the CFA Institute’s director of investor education. He likens these businesses to real estate investment trusts. Just as most investors have to buy a REIT listed on a stock market to get exposure to expensive real estate assets, so too must they buy a publicly listed private equity company to get access to private businesses.

Most private equity investment companies don’t pay REIT-like dividends, however. Berkshire Hathaway pays no dividend at all, and Brookfield Asset Management has a paltry 1.52% yield. But because their assets tend to perform better during better economic times, these stocks often see higher returns than other parts of the market during upswings, says Stammers.

The S&P Listed Private Equity Index, which tracks the performance of publicly listed private equity operations, is up 35% over the past 12 months and has a 19.93% five-year annualized return. That’s better than both the S&P 500 and the S&P/TSX composite index’s returns. When times are tough and private company performance takes a hit, though, these stocks can fall hard. “These are for people who are looking for something to juice returns,” says Stammers. “You are taking on extra risk.”

You also have to accept less transparency. You won’t get the same quarterly disclosure of the underlying assets’ performance as with pure-play public companies, says Richard Nield, a portfolio manager with Invesco. Freed from having to meet sales targets every quarter, managers can make drastic operational changes if need be. The holding company’s cash flow comes from dividends paid out by the companies they own. Some companies, like Brookfield, also collect fees for managing assets shared with institutional partners. Of course, the big payoff comes when the holding company sells an asset, though much of that money often gets funnelled into the next purchase.

When looking for a publicly listed private equity company, the most important factor is management’s track record. One challenge for investors is that it’s difficult to understand the businesses these companies own. Investors don’t get to see the private companies’ financials, so you have to have faith in the executive team. “Your investment return is entirely driven by how management creates a transaction, how much leverage is used, who is sent in to manage that company, how long they keep the company and more,” says Dupont.

Hence, past performance has more than the usual bearing on future performance, says Stammers. Look for a history of strong returns, management continuity, prudent investments and how a company handles itself in a downturn, he says, adding that the best management teams will often have their pick of the best companies. Also look at whether or not the company has other lines of business—some of these companies, like Berkshire, own large stakes in public firms in addition to their private holdings. One isn’t necessarily better than the other, but a more pure-play private equity business could perform differently than one with a more diversified earnings base.

Stammers recommends investing no more than 10% of your portfolio in these types of businesses. Nield cautions that because of strong year-to-date gains, there could be a short-term pullback. Stick around for the long term, though, and returns should outperform.