The term Private Equity refers to the acquisition of equity shares that are traded privately, not publicly on the market. Equity holdings are traded off-exchange when, for example, a business division is to be sold or no internal successor can be found to manage a business.

At this point, we must make a clear distinction between Private Equity (PE) and venture capital (VC). Private Equity is characterized by the fact that it is invested in established small and medium-sized companies or in large corporations. Venture capital, on the other hand, is primarily invested in new and innovative companies (also commonly referred to as risk capital).

In the Private Equity industry, equity shares are purchased by funds that are administered and managed by managers and their teams. Private Equity funds normally have a term of 10 years and are only available to institutional investors. These funds acquire holdings in 10-20 companies with the above characteristics during the initial investment period of around 5 years.

The goal of each investment is, together with managing the acquired company, to develop a strategy for implementing value-generating measures and to implement these within 3-6 years. Value is created through organizational and company growth, growing operative profitability, and increasing cash flows, or through acquiring companies that provide synergistic effects (add-ons).

Private Equity companies are temporary owners. The investments are sold, with the proceeds flowing back to the investors in the fund, after the business plan has been implemented successfully. If all investments have been sold, the fund is liquidated.

Private Equity funds receive an annual management fee as fixed compensation. Additional performance-based profit shares (carried interest) are only available to the fund if the investors have achieved a minimum return in a specified amount (hurdle rate).

As an equity investment, an investment in Private Equity gives you the opportunity to share in increasing the value of a company. Many analyses show that continuous Private Equity investment programs are capable of achieving above-average returns. There are many reasons for this:

Functional Incentive System through Personal Investment
The management of the company purchased, as well as the fund managers, invest their own capital, thus giving them personal interest in leading the company successfully and increasing its value.

Increased Value through the Implementation of Long-term Business Plans
The value multipliers identified during the run-up to acquisition are implemented in a consistent manner. The company is managed by the fund over many years, which creates a focus on long-term considerations rather than short-term quarterly goals.

Rapid and Short Decision Paths
Because of the flat hierarchies typical to Private Equity funds, it is possible to make decisions quickly.

Leveraging Returns on Equity through External Financing
By and large, Private Equity funds finance the purchase of a stake with debt. When selling the company, however, the increase in value achieved returns to the equity investors. External creditors receive only the loan amount and the fixed interest.

Low Dependence on Decision Timing
Returns on liquid assets are often determined by the timing and frequency of purchase and sale decisions that are subject to limited information. Longer review processes are normally required for transactions involving the purchase and sale of Private Equity. Trading approaches typical to stocks do not play a role with Private Equity.

The investment and sales process of Private Equity funds is an important reason for their independence from market timing. Investments are made incrementally over a period of 4-5 years, with sales occurring during a second phase of another 4-5 years. This results in an income and payment structure for investors, which is referred to as a “J curve” because of its shape.

Equity investment
Investments in private equity are investments in the equity of companies. This investment can lead to a total loss if the companies perform worse than expected.

Market environment
Acquired companies may perform worse than expected due to an adverse market environment.

Business environment
The environment of the companies and the private equity funds may develop adversely due to changes in the legal and tax framework.

Tradability
Shares in private equity funds are not tradable in an organised market and are therefore illiquid. This long-term nature of the investment, although at the same time an opportunity for sustainable growth, severely restricts investors’ ability to act when liquidity is needed.

Blind pools
As a rule, the target funds are so-called blind pools, since the final target companies are not fully known at the time of the closing of subscriptions. Even if the investment strategy of the funds is defined in terms of regions, company sizes and industries, the specific companies are not yet identified at the time of the investment decision.

The low interest rate environment of recent years has led to a growing demand for private equity. The high investment demand of institutional investors, however, focuses mostly on the large and mega cap end of the fund market. As a consequence, only a small fraction of new capital flows into the analysis-intensive and granular area of small and mid cap companies and funds.

We take advantage of this dynamic, as the lower capital flow and the much more frequent transaction opportunities result in significantly more attractive valuations at entry. On the one hand, this reduces the risk of loss over the term of the investment, and on the other hand, it increases the return potential in an exit.

The investments in the Astorius funds are in established, successful companies. Nevertheless, companies of this size are rarely already perfectly organised, set up and structured. This imperfection offers potential for value enhancement to experienced fund managers. Complex shareholder structures across different generations, a lack of readiness for regional or product expansion, or rudimentary reporting procedures are typical examples of entrepreneurial deficiencies that private equity funds can address.

Acquisitions are also an opportunity to add value by integrating smaller competitors or strategically important expansions to the company. They can accelerate operational expansion, cost savings or direct revenue and profit growth. This strategy is referred to as “Buy & Build”.

The dynamic of increasing competition for larger transactions mentinoed above means that a successful small and mid cap investment can be doubly rewarded in an exit. A buyer will pay a premium for the improved sales and margin profile, but also the relative valuation in relation to earnings (“EBITDA multiple”) increases for a larger company. Our return targets should be achieved independently of this so-called “multiple expansion”, but we are always happy to benefit from this valuation bonus when it is achieved.

In addition, the companies in our portfolio can be sold rather flexibly due to their size. IPOs which are a dependent on the health of stock markets play only a very minor role.

The reasons already mentioned explain the structurally higher return potential of medium-sized companies, which in the past has led to the far above-average performance of the best managers of small and medium-sized private equity funds. But the risk is also often lower in small funds.

From the stock market, many investors are used to the rule of thumb “the smaller the riskier”. Small cap stocks and funds often have higher volatility than larger stocks.

For small and medium-sized private equity funds and their investee companies, however, this simple inference from size to risk does not usually apply. On the contrary. As already seen, smaller investments are often acquired at lower valuations, which automatically provide a risk buffer. In times of crisis, established SMEs have often proven to be more robust than large companies and corporations. This is mainly due to the usually lower leverage of smaller companies and the greater speed with which decisions and countermeasures can be made and implemented.

This positive characteristic of small and medium-sized private equity funds is also well documented in academic research: Small is beautiful 2.0, Gottschalg et al. (2017)

A key challenge in private markets is identifying the best fund managers. The dispersion of private equity fund results is high and the selection of funds therefore offers great opportunities. Unlike in the world of mega funds and large corporations, personal factors at the fund and company levels play a correspondingly greater role in small and mid cap. It is therefore not enough to evaluate the operational talent of a fund from past transactions. Rather, investors need to get a comprehensive perspective on the team’s internal interactions, linkages to transaction sources, relationship with investee staff, etc.

Data availability for smaller funds is also significantly reduced. Therefore, a great deal of investigative and experience-based effort must be put into recording and evaluating the investable offer.

In return, however, the best small and mid cap funds offer return opportunities that are far above-average.