Private equity firms use capital, usually committed by large institutions, to invest in different companies. Often their investments are riskier companies at the start-up stage, so the returns can be quite large if these businesses become successful.
Recently, a sub-category of private equity, listed private equities (LPEs), traded on the stock exchange, are gaining popularity in the U.S.
“Until now, the whole section of private equity, from a small investor’s point of view, wasn’t accessible. With this emerging trend of LPEs, every investor, including the smaller players or individual investors, can invest a portion of their wealth into private equity and get that exposure,” says Sinan Goktan, Ph.D., assistant professor of finance in the College of Business and Economics at California State University, East Bay.
Smart Business spoke with Goktan about how LPEs work, and the performances of companies backed by LPEs versus traditional private equity firms.
Why are LPEs growing?
When anyone is able to purchase shares in an LPE firm, gaining exposure to the private equity market, investors can further diversify their financial portfolios. This new asset class is drawing capital into the private equity market from a new investor group and the flow of capital is continuous (since the firm is listed), unlike the traditional private equity capital that has a typical investment horizon of eight to 10 years. Eventually, a traditional private equity fund needs to be exited and new capital needs to be raised, which can be costly. The appeal of access to public markets as a continuous source of capital is leading more private equity firms, especially the larger ones, to list themselves. At the same time, LPE investments are more flexible and liquid than unlisted private equity.
Although LPEs are more established in European financial markets, particularly London, some big U.S. firms are Blackstone, KKR and The Carlyle Group.
How are LPEs different than unlisted private equity firms?
Both private equity types function similarly, except in how they raise capital. However, research with my co-authors Volkan Muslu and Erdem Ucar has shown that there’s a difference in how the companies they invest in perform in the long run.
When LPE-backed companies go public, they are more conservative and reliable in how they report earnings before and after the initial public offering (IPO) year. They also are timelier with recognizing losses. LPEs are subject to greater scrutiny by the SEC due to being listed in an exchange. Our results may be attributed to the higher reporting requirements of LPEs spilling over to the companies they are backing.
More reliable numbers mean more control and less risk for the investor. Traditionally, with unlisted private equity, potential new investors didn’t know much about private equity-backed companies’ progress until the IPO. The relatively timely and accurate financial information revealed by LPE firms has an impact in financial markets.
How else does the type of private equity backing affect an IPO?
Looking at the example of Facebook, if there’s lack of information, analysts will come up with wildly different price estimates. Because of their nature and the greater information content with the LPE-backed companies, the first day’s pricing is more accurate, which creates a lower initial return. Since companies revisit the financial markets repeatedly, they need to earn the trust of investors by providing accurate information in a timely manner to generate price stability.
What does your research suggest about increased disclosure requirements?
With passage of the Dodd-Frank Act, even unlisted private equity firms must file information with the SEC. Recent evidence suggests that investigators also are more likely to approach small private equity firms to ask for more information about their investments. Thus, the more opaque the private equity firm, the more information is required. Ultimately, the general trend is that investors are increasingly seeking more financial information before committing capital. Companies will either choose to reveal better quality information themselves, or the SEC will probably require them to reveal more information as needed. ●
Sinan Goktan, Ph.D., is an assistant professor of finance in the College of Business and Economics at California State University, East Bay. He teaches finance in the MBA Program. Reach him at (510) 885-3797 or firstname.lastname@example.org.
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