What factors lead to higher returns on private equity investments?

Private equity (PE) is a form of alternative investment that involves buying and selling stakes in private companies, often with the aim of improving their performance and value. PE investors typically use a combination of equity and debt to finance their deals, and seek to exit their investments after a few years, either through an initial public offering (IPO), a trade sale, or a secondary sale. But what factors lead to higher returns on private equity investments? In this article, we will explore some of the key drivers of PE returns, and how they can vary depending on the type, stage, and strategy of the PE fund.

1 Fund size and diversification

One of the factors that can affect PE returns is the size and diversification of the fund. Larger funds may have more resources, expertise, and reputation to access and execute deals, but they may also face more competition, higher valuations, and lower growth potential. Smaller funds may have more flexibility, focus, and niche opportunities, but they may also face more risks, challenges, and volatility. Therefore, PE investors need to balance the trade-offs between fund size and diversification, and align their expectations and objectives with the fund's target market and portfolio composition.

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2 Deal sourcing and selection

Another factor that can influence PE returns is the deal sourcing and selection process. PE investors need to find and evaluate attractive opportunities that fit their investment criteria, such as industry, geography, growth stage, value proposition, and competitive advantage. They also need to conduct thorough due diligence, valuation, and negotiation to ensure they pay a fair price and structure the deal in a way that aligns the interests of all parties. Moreover, they need to consider the exit potential and timing of each deal, and how it fits into their overall fund strategy and cycle.

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Saad Adada, CFA

Founder and CEO of Mnaara | investment management and advisory | Fintech | Islamic Finance
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Private Equity investing is increasingly utilizing AI to deliver value throughout the investments' process; from deal origination and assessment to ongoing portfolio engagement. A recent LP survey done by Coller Capital shows that 75% of participants see the usefulness of AI in deal origination.

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3 Value creation and exit

The third factor that can impact PE returns is the value creation and exit phase. PE investors need to actively monitor and support their portfolio companies, and implement operational, financial, and strategic improvements that can enhance their performance and value. They also need to plan and execute their exit strategy, and choose the optimal exit channel, timing, and price that can maximize their return on investment. Additionally, they need to account for the fees, costs, and taxes associated with each deal, and how they affect their net returns.

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Kelly Ann Winget

📚📖 Author of 'Pitch the B!tch 📚📖 | Founder | Investor 💵 | Speaker 🎙️| Alts Expert | Investor Advocate | Family Office Advisor
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I believe that unique, actively managed PE portfolios will out perform most asset classes over the next decade. As more investors are looking to invest in innovative, next generation solutions, PE managers are going to have to get creative with their strategy. As an active, emerging manager, I lean into my diverse experience as a woman, a minority and a contrarian. These differences allow me to tap into an alpha that my competition overlooks.

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4 Market conditions and performance benchmarks

The fourth factor that can affect PE returns is the market conditions and performance benchmarks. PE returns are influenced by the supply and demand of capital, the availability and cost of debt, the valuation and liquidity of assets, and the macroeconomic and industry trends. PE returns are also measured and compared against various performance benchmarks, such as the internal rate of return (IRR), the multiple of invested capital (MOIC), and the public market equivalent (PME). These benchmarks can help PE investors assess their absolute and relative performance, and adjust their strategies accordingly.

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Saad Adada, CFA

Founder and CEO of Mnaara | investment management and advisory | Fintech | Islamic Finance
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As private companies’ valuations are highly impacted by public market prices, private equity fund returns are influenced by the timing of when the funds are raised and deployed, so-called the vintage year. Investments made during recovery periods have consistently outperformed long-term averages.

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5 Fund governance and alignment

The fifth factor that can influence PE returns is the fund governance and alignment. PE investors need to establish and follow clear and transparent rules and processes for their fund management, reporting, and decision-making. They also need to align their interests and incentives with those of their fund managers, portfolio companies, and co-investors, and avoid any conflicts of interest or agency problems. Furthermore, they need to comply with the legal and regulatory requirements, and adhere to the ethical and social standards, of the markets and sectors they operate in.

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6 Investor skills and experience

The sixth factor that can impact PE returns is the investor skills and experience. PE investing requires a combination of analytical, financial, strategic, operational, and interpersonal skills, as well as a deep understanding of the markets, industries, and companies they invest in. PE investors also need to have a long-term vision, a disciplined approach, and a high tolerance for risk and uncertainty. Moreover, PE investors need to learn from their successes and failures, and constantly improve their knowledge and capabilities, to achieve higher returns on private equity investments.

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