An Introduction to Private Equity

By Stephen Rosen on January 19, 2023

When it comes to investing, there are many options available.

This time the focus is on private companies with great growth potential and what we should take into consideration before investing.

In this episode, Stephen Rosen provides an overview of the private equity space, including its advantages and risks. Additionally, Steven explains what private credit is and how it helps investment firms obtain funds.

Stephen discusses:

• The concept of private equity and how it differentiates from investing in a publicly traded company
• How important is it for investors to have patience in this type of investing
• The reason why the number of publicly traded companies has decreased over the years
• Why most companies prefer staying private for a long time
• The importance for investors to handle illiquidity
• How working with top-tier managers can be beneficial
• Private credits and why many private investors rely on them
• And more!

Connect With Stephen:

• srosen@hightoweradvisors.com
• Hightower Bethesda
• LinkedIn: Stephen Rosen
• 301-202-3582

Publishing Tags: Approach Investing Differently, Hightower Bethesda, Stephen Rosen, Investing, Private Equity, Investing, Businesses, Startups, Funding, Capital, Private Credits, Banks, 

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[00:00:00] You invest your money strictly in stocks and bonds. If so, it’s time to change that. Welcome to Approach Investing Differently with me, Stephen Rosen from Hightower Bethesda. I’ve been advising clients for over 20 years on how to invest in alternative investments, and I’ll explain why you should dedicate a percentage of your investable assets to hedge,

[00:00:23] private equity and real estate in order to maximize returns and create a more efficient investment portfolio. Now onto the show.

[00:00:39] Private equity can play a key role in an investment portfolio, but Stephen Rosen is here with an introduction to the space and the possible benefits and risks. I’m Patrice Sikora.  Stephen, let’s start with a basic definition. What is private equity? Good question. And for starters, thanks for [00:01:00] joining me again, Patrice.

[00:01:01] Really appreciate all the help you’ve done and I hope our listeners are enjoying the podcasts that we’ve put out so far. So we’ve focused so far on hedge funds. The different kinds of hedge funds that we invest. We focused on the last couple of episodes on real estate and the different ways that we can invest across that avenue.

[00:01:22] And now it’s time to turn our eyes to private equity and private credit. And private equity is one of the most valuable assets, I think, from an investment standpoint. But one of the things that we were really always looking for is, people who can invest in good companies. And so, the whole notion behind private equity is really trying to find business owners like ourselves and like many of our clients and investing alongside of them.

[00:01:49] Helping them grow their business. And again, like always, we’re always utilizing managers who have an expertise to do it. But what we’re really looking to do is invest along companies as [00:02:00] they are in their earlier stages of growth and giving them an ability to really maximize their potential. And what’s nice about being private is they’re always making decisions about the long term.

[00:02:11] Unlike publicly traded markets, who we find many times are publicly traded equities, I should say, who are many times making decisions based upon what analysts are looking at on a quarter by quarter basis. Or what boards are looking for on maybe a year to year basis. And they’re sometimes a little bit shortsighted in how they manage their companies versus privately held companies who are always looking out, you know, 3, 4, 5 years.

[00:02:35] For the most part, you’ve got to face it, I mean, most of the time people they are responsible to or responding to a board or to their investors and they do have to make decisions. They do. But at the end of the day, the people who are investing in private equity are investing from a different standpoint.

[00:02:53] So generally speaking, we’ve got different stages of private equity and we’ve got a future podcast where we’ll go a little bit [00:03:00] deeper into,  the different stages of private equity. But your general basic stages of private equity would be seed capital, venture capital, growth, capital, late stage. And so, depending upon where you are in that spectrum of investing, going from earlier to later, you have different time horizons.

[00:03:18] And that’s one of the things that’s very important to understand. And it’s one of the things that we educate our clients on all the time, which is what are your expectations from an investment, both from a return standpoint and a timeframe standpoint. So, if you are investing in a company, you know, whether it be seed or venture, and you’re very early on, you have an understanding that you’re not going to see your money in all likelihood

[00:03:43] back from a very meaningful return probably for somewhere between four to six years. And so, the people who were investing are understanding that process and they’re there to help guide the business owners in a way to [00:04:00] maximize their investment over the course of four to six years. They understand that it takes time for these companies to grow and achieve the success that they’re looking for.

[00:04:10] They’re not looking for instantaneous, they’re not really worried about a quarter by quarter number. They’re really looking at the big picture because there’s no stock price that’s moving up or down on a day-to-day basis. You don’t have 20 different analysts from all the major investment banks and research firms that are judging you on a day-to-day basis.

[00:04:32] You have your board who is very well aware of what’s going on. They generally are letting the business owners run the companies the way they want to, giving them help and guidance along the way and support. But at the end of the, it’s a timeframe that we’re looking for, which is very, very different from the publicly traded markets.

[00:04:51] Now, historically did investors and owners need to take their companies public faster? Are we in a different kind of market today? Great [00:05:00] question. Yes. We really are in a very, very, very different market, and that’s kind of evolved over the last several years. So, if we look back, 20 years ago, and we’ve talked about this on prior podcasts, when we take a look at maybe sometimes how we, you know how at Hightower Bethesda, we run our equity portfolios which we haven’t covered in this series, but we’ve done in another in other venues.

[00:05:21] And we are index investors. And we’re index investors because we think it’s very difficult to outperform the publicly traded markets on a year to year basis, and particularly over a long term when you factor in, you know, fees and taxes, et cetera. And one of the reasons for that is because the publicly traded markets have shrunk dramatically

[00:05:40] over the years. So there used to be, or actually still is, an index called the Wilshire 5,000. Okay. Most people are familiar with the S&P500, that’s got 500 stocks in it. The Dow Jones that has 30 stocks in it. Wilshire 5,000 was, you know, kind of a total market index that people [00:06:00] looked at many, many, many years ago.

[00:06:02] Well, there’s a little bit of a problem, right? The Wilshire 5,000 is not exactly the Wilshire 5,000 anymore because there aren’t 5,000 publicly traded companies. All right, so it’s a very different world that we live in. The number of publicly traded companies have shrunk dramatically over the years, and it’s a byproduct of a couple of things.

[00:06:22] Number one is companies are being scooped up. Private companies are being scooped up by other publicly traded companies. Publicly traded companies are looking for strategic acquisitions. And therefore, um, maybe a company that used to go public, you know, 10, 15, 20 years ago doesn’t come public because they’re scooped up by, you know, it doesn’t have to be a competitor, but it could be somebody who’s looking to access or, or, you know, the, or enter, uh, into that.

[00:06:48] And we’ve seen that in, in many, many instances across the board, uh, particularly in the technology. But one of the main changes is liquidity. And what I mean by liquidity [00:07:00] is the ability of investors in private funds or private companies to get their money out without the companies having to go public.

[00:07:10] And that has changed dramatically over the years. How so? So, it used to be that you’d invest in a privately held company. You’d get a meaningful return, you’d get compensated for your illiquidity. And the companies would go public, you know, after a couple of years. Maybe they’d, be valued at, you know, 200 million, 300 million, 400, 500 million, and then they’d go public and then there’d, you know, be a whole other upside to the stocks once they get p traded in the public markets because they were impossible to own.

[00:07:43] Well, what’s changed over the last, five or 10 years.  There’s been a creation of these secondary markets or in many instances, some of these late stage investors who come in and what they do is they’re basically willing to buy shares [00:08:00] of executives, early investors, because there’s different return metrics that each of these people are trying to look for.

[00:08:07] The people, and again, we’re not going to get into detail, but the people who are seed capital investors, they want, you know, multiple, multiple, multiple times their return when they put money in a late stage person they just might be looking for a good return. Nothing too crazy because a lot of their risk has been taken out.

[00:08:27] So, because those seed capital investors now have a possibility to get their money back so they can then go dedicate it to another investment, they now have the ability to get their capital out, which then allows the privately held companies to stay private for longer.  And to be truthful, most companies prefer to stay private as long as they possibly can.

[00:08:52] A lot less regulations, a lot less hassle. Again, dealing with the publicly traded markets, dealing with all the analysts, the [00:09:00] ups and the downs, and the volatilities. And just again, as I’d mentioned to you, taking the focus off the business and, and dealing with so many other things. So, the ability for these companies to stay private longer

[00:09:10] has dramatically changed a couple of things. Number one, these companies are now coming public at, you know, 30, 40, 50, 60, a hundred billion valuations. Well think about that for a second. You have a company that starts at zero and comes publicly traded at. 20, 30, 40, 50 billion. I was going to say, even, even 10 times, I’ll go with that.

[00:09:37] Right. But my point is that you’re seeing this exponential growth occur along so many different stages of investors versus that, by the way, the average Joe can’t access, right? And isn’t accessing. So, you’re taking this massive level of growth on the private market side, and these companies are having the ability to stay [00:10:00] private longer.

[00:10:00] So what you’re seeing is, so much of the return of these companies is coming to the private investors, not the public investors. The public investors then get stuck at the whim of what the markets and the economy are doing, rather than the growth of the company. Hundreds of thousands or tens of thousands of companies out there right now that are growing their earnings and growing their revenues, and they’re seeing the value of their businesses increase, even if the equity markets are going down and the economy is going down.

[00:10:34] There’s less correlation between publicly traded companies and privately traded companies because the publicly traded companies are not only valued based upon what their earnings are, they’re valued on what the multiples that people are paying for and whether or not they also want to apply some kind of premium or discount to whatever valuation they want to put on.

[00:10:55] And plus, they’re just also at the whim because of the increase in indexing, they’re at the [00:11:00] whim of the publicly traded markets. Private companies don’t have that issue. Private companies are kind of sitting out on an island, hopefully growing, increasing their revenue, increasing their earnings, and therefore their pricing is not as volatile as the day-to-day volatility that we see in the equity markets.

[00:11:20] And that again, is one of the reasons why we thoroughly enjoy that segment of the market, similar to how we’ve talked about hedge funds and real estate, lack of volatility. And if we can keep volatility down for clients, they have a much more calm experience as far as investing is concerned, and they don’t go overboard with the ups and the downs of the market.

[00:11:45] You’re talking about less volatility, but I’m also hearing you talk about superior returns. So, you know, we don’t like to talk about returns, this is true. This is true. Okay. But look, what you’re always hoping [00:12:00] for in any illiquid investment is that you are earning what we call an illiquidity premium relative to purely liquid investments.

[00:12:12] And history does show us that private equity dramatically outperforms public equity. You, again, similar to our hedge funds, similar to real estate, you have to be able, as an investor to handle the illiquidity of that investment. Whether that handle I is different for different people. Handle for some people is just the inability to get out.

[00:12:39] It could take a couple of years for you to get your money back. You have to be able to balance how, particularly for people who are, you know, approaching retirement or even in retirement, these are investments that are suitable for them as well, potentially. But again, you have to measure how much money do they need to live on and can they handle the [00:13:00] illiquidity.

[00:13:00] You then also come back to everything that we’ve talked about on these podcasts for so long, which is making sure that your own good. And not just getting access to a private equity fund, hoping that that’s a high quality fund. Truth of the matter is that there’s a lot of not so good private equity managers out there.

[00:13:20] Same thing with real estate, and same thing with hedge funds. A and a, it’s really interesting. I actually had a meeting with a prospect the other day, and we showed him a sample report of a client and performance of that because I’m a big fan of showing real life returns, not hypotheticals, which they appreciated.

[00:13:41] And we break out our performance reports for clients in three segments. So, they’re fixed income, they’re equities and they’re alternatives. And in general, as you one would expect, your fixed income returns should be within shouting distance of a benchmark. Your equity returns should be within [00:14:00] shouting distance of a benchmark.

[00:14:01] But when we take a look at the performance of alternatives, returns, they are exceptionally higher than the benchmark. Now, there’s two reasons for that, but primarily one of the biggest reasons is the benchmark for hedge funds in general. It’s just god awful. Okay. And so I said to the prospect, he’s like, well, tell me about this benchmark.

[00:14:25] And I’m like, well, let me tell you.  If you’ve noticed, when I talked about the historic returns of our alternatives, I never once gave it in the context of the benchmark. I kind of give it in the context of how bonds have done and how stocks have done, because the index itself is just awful. It’s a blended index.

[00:14:42] It also takes into account a large swath of managers on all different strategies. But it also has top tier and, you know, top quartile and second quartile and third quartile and, and bottom quartile. And the truth of the matter is, is that when you take a look at the, you know, bottom 50% [00:15:00] of private managers almost across all asset classes, that’s publicly traded equities and private real estate and private equity and private credit, which we’ll talk about.

[00:15:09] Truth of the matter is, is bottom quartile managers just think. , they’re just not good . And so when, when you have an index that’s made up of that, um, it kind of skews things a little bit. And so we’re very particular, or, or cautious I should say, when we do talk about these things and really understanding the importance of making sure that you are accessing top tier strategies.

[00:15:33] We talked about this in hedge funds. We talked about it in private equity, I mean private real estate, and truth of the matter is, same thing holds for private. You have to be in high quality managers. And everybody knows who they are. The question is, do you have access to them? And I come back to, we’ve been doing this for over 20 years.

[00:15:53] We have tremendous relationships. And I think we do have access to those top tier managers. And the nice thing about those top tier [00:16:00] managers, the reason why they stay top tier is because they all see a lot of different investment opportunities, but it’s your top tier managers that kind of get first crack at what ends up being the better companies.

[00:16:16] And so success begets success. You mentioned private credit. Talk to me about that. So private credit is, think about it from this standpoint, when a company, there’s a couple of different ways to invest in private credit, but think about it from some sort of this general standpoint, first and foremost, when a company is bought, okay?

[00:16:42] So again, we’ll get into the different details of private equity investments. Not just the stages, but also the types of investments. But I’ll give you a very simple basic example. One such example, you know, it’s called a leverage. [00:17:00] Okay. For private equity where sometimes miss it, this particular instance, a lot of times you’re taking maybe a publicly traded company,

[00:17:08] okay, who was kind of floundering, wasn’t growing as well as they should be. Maybe the market just wasn’t, value them valuing them, the manner in which they should, maybe they’ve got a couple of, you know, really high quality divisions inside the company that they maybe want to access, maybe sell off some of the ones, the parts that aren’t working so much.

[00:17:28] But what happens is, these private equity managers or investors will come in, they’ll buy a company. And what they will do essentially is take some money of their own, they’ll invest it. That’s the equity portion of it. And then what they do, similar to when somebody goes and buys a house, they put debt on the remaining aspect of it.

[00:17:52] And the nice thing you know about debt is generally ahead. Well, you are not generally, you always are ahead of the equity [00:18:00] investors. Okay? So God forbid something goes, okay. The equity investors lose before the debt investors lose. And if you have the ability to invest in private credit correctly, and in this instance you know the leverage buyout, and you are finding credit managers who are investing with some of the best private equity managers who again, are in the business of making money, your losses become a lot.

[00:18:29] Okay. Now your compensation, your earnings that you get are generally not near what you get on the private equity side, but when you take a look at your returns relative to traditional bonds, whether they be treasuries or just, you know, municipal bonds or corporate bonds, you’re getting  much, much, much higher

[00:18:50] on the private credit side than you are on the publicly traded side for bonds. And again, it comes back to the illiquidity premium that [00:19:00] you see across the board. And there’s different ways of investing in private credit. And again, not to steal the thunder from future podcasts that we’re going to get into, more detailed background of private credit because I think that it’s a great place to invest.

[00:19:16] Again, I don’t like to be timely in things, but the last several years have been mediocre. In the credit cycle. Again, interest rates being at all time lows, no matter where you invest in the world. When interest rates are at all time lows, it is very difficult to earn a meaningful return without taking on too much risk.

[00:19:36] So now what we’ve seen interest rates increase dramatically over the past year. We’re seeing a lot of opportunity in the private credit market and in many instances you can almost, private credit, you can get the returns in the private credit market that you would probably expect on an annualized basis from equities.

[00:19:55] And so in that instance, again, it comes back to risk [00:20:00] reward. If we can get expected or historic equity returns with credit risk, well hey, that’s a very, very, very attractive spot to be in. And it’s something that we haven’t looked in a very long time. So, and again, there’s different types of private credit investments.

[00:20:16] You can do bank loans. You can do just traditional high yield, which again, privately held companies, there’s a lot of asset backed securities that you can invest in. Those don’t always have to, you know, those aren’t generally in what we would call the leverage buyout, world asset backed securities.

[00:20:33] could be anywhere from, company buying receivables. Okay. At a discounted level, you know, prepaid loans, insurance policies, which, you know, sometimes can be a little bit of a sleazy area, but, it is something that people do look at. And then there’s also distressed investing in the private credit markets where, you know, somebody might take a look at a company who’s really struggling and, and maybe they’ll end up buying their [00:21:00] bonds at an exceptionally low level.

[00:21:02] So there’s a lot of different unique ways, but again, it’s about blending them all into a portfolio that maximizes in our eyes, returns, okay, for the appropriate risk that one is willing to take. Setting up private credit. Is there a downside? Can somebody pull out at the last, saying, oh, I thought I could fund this and I can’t.

[00:21:31] Now you’re going to have to go someplace else. So that’s a really interesting thing. So, what’s happened over the last couple of years? Or really maybe, I’d probably go almost towards the global financial crisis. Okay. And this is something that we talk about with our funds that we’re looking to invest with because people think that it’s very easy for investment banks or general banks to lend money.

[00:21:59] [00:22:00] And the truth of the matter is, it’s. Okay. We all think, and many people have experienced this on a personal level from a mortgage standpoint, look, you have a great living, okay? You’ve put away a lot of money. You have equity in your house or houses, okay? And you go to get a mortgage and your credit is great, but you are jumping through 8,000 hoops, okay?

[00:22:30] To get your mortgage and you’re thinking to yourself, this really shouldn’t be this difficult. Yes. Okay. And so, I think people who are listening to this have pretty much all been through the ringer over the last five to 10 years of buying a house, refinancing, et cetera. Now buying a house creates a little bit of a stress on the mortgage side.

[00:22:54] Refinancing sometimes, you know, if it takes a little bit longer, it takes a little bit [00:23:00] longer and you’re just, you know, I’ve always guided clients over the last bunch of years to say, hey, look, this is just the process. It’s annoying, but you’re going to get a 30 year mortgage for two and a half percent.

[00:23:10] Like if you have to jump through hoops for 30 year mortgage and two and a half percent, just kind of suck it up and move on. Okay. Well, that’s fine for you and I all. When you’re talking about companies trying to buy other companies, the risk that a bank goes through months of due diligence tells you that they’re going to come to the table with the money.

[00:23:41] We’re going to come, we’re going to be there, we’ll be there to close the deal, we’ll be able to lend you the money, and then some event happens. That has absolutely nothing to do with you, okay. Economy changes, God forbid. You know there’s a war somewhere, and all of a sudden [00:24:00] the powers that be at the traditional banks step back and say, hey, you know what?

[00:24:04] We’re not comfortable lending in that segment of the market now. Okay? No real rhyme or reason. Just the banks are taking down risk and now all of a sudden these private credit investors who you know, really this applies to the private equity investors who are going to get loans from the banks to close these private equity deals.

[00:24:26] Now all of a sudden they’re left at the table and they can’t close their private equity investment because they need. And so, what has gone on more and more over the last bunch of years is these private equity companies, because again, I come back and say they are making multiples on the money they invest.

[00:24:51] They’re willing to pay a little bit of a higher interest rate to these private credit funds because the private credit funds [00:25:00] are willing to take on a little bit more perceived, they have partners that they’ve worked with. They know they’ll come to the table with the money when it’s time for the deal to close, and they’re not going to get spooked

[00:25:14] by any changes in the economy or the markets or anything because their job is specifically to invest in private credit. And so, I ask these questions and now I know the answers cause I’ve been dealing with this for so many years, but it used to never really make sense to me. I’d always say, well, I don’t understand interest rates are 4%.

[00:25:36] Okay. And you guys are getting nine, okay. Or interest rates for high yield bonds are 7% and you guys are getting 12%. Like, I don’t understand why are they not going just the traditional bank route? And they’d explained over and over and over again and now a clearly, you know, five and 10 and 15 years later investing in private credit.

[00:25:59] I [00:26:00] don’t ask that question anymore. I understand it. The reality is that these companies can afford to pay an interest rate for the guarantee that someone’s going to be there when they go to close their deal. And so, as the banks have gotten more risk adverse, it’s opened up a major opportunity for the private credit funds.

[00:26:23] And I think for investors who are working with people and understand what it is that they are able to access, I think, and find themselves in a position of getting again enhanced returns. In exchange for some level of illiquidity. Great discussion there, Stephen. Absolutely insightful, very insightful. But we’re going to wrap up this podcast with the caveat that the next episode is going to be taking a much deeper dive into private equity.

[00:26:54] So make sure you don’t miss that episode. And how can listeners reach you if they have [00:27:00] additional question? As always, best place to go is our website, hightowerbethesda.com. You can grab anybody’s phone number there and reach out to us or email us if you’re interested. And you’ll see a ton of great content from our various podcasts that we’ve been running, newsletters and that’s kind of the best way to do it, and we look forward to hearing from anybody and everybody.

[00:27:23] Fantastic. Follow this podcast. You’ll get access to every episode, and of course, share with others. Thanks for being with us.

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