Private equity (PE) has long been a coveted asset class for investors seeking high returns, long-term value creation, and potential portfolio diversification. However, traditional PE investments often come with high fees, long lock-up periods, limited accessibility, and cyclicality in distributions. Enter liquid private equity – an innovative approach that aims to capture the benefits of PE investing through publicly traded securities.

Understanding Liquid PE

Liquid private equity seeks to match the key return drivers and characteristics of traditional PE investments using publicly traded stocks. This approach offers several advantages:

• Increased liquidity
• Lower fees compared to traditional PE funds
• Greater transparency
• Easier access for a broader range of investors

Many arguments can be made about the similarities between private and public equity investments because they are both equity stakes in businesses. To start,  the PE industry itself uses comparable public companies in valuing its portfolios (perhaps somewhat selectively throughout the market cycle), and, at a more fundamental level, both public and private companies are exposed to the same macroeconomic, industry-specific, and other top-down trends.

Two competitors in the same industry – one public, one private – can have different sources of revenue, but they are still subject to the same dominant trends that pervade industries and can sometimes impact almost the entire economy.

Most of these macroeconomic and other top-down forces don’t distinguish between public and private companies. For example, a publicly listed company that is a major supplier of construction materials to homebuilders in a specific geographic region is going to be tied to the housing cycle in a very similar way as a privately held company that is also a major supplier of construction materials to homebuilders in the same region. Furthermore, in our opinion, most buyers of goods and services make their purchasing decisions with little regard for whether the company they are buying from is publicly listed or privately held.

The Case for Liquid PE  - Correlation with Traditional PE

Studies have shown a 75% correlation between the total returns of PE and the public equity market, using the Preqin Private Equity ex-Venture Capital Index and the Russell 2500 Index as proxies.1 This high correlation suggests that even a simple passive exposure to public equities can serve as a reasonable proxy for PE returns. This may not come as a surprise since, at the end of the day, private and public equity investments both involve ownership stakes in companies that have shared beta. Importantly, as one tilts away from a broad public equity market exposure and shifts that exposure more toward the primary drivers of traditional PE returns, the higher this correlation becomes.

How to Invest in Liquid PE - ETFs Focused on Liquid PE

One of the easiest ways to gain exposure to liquid PE is through exchange-traded funds (ETFs) designed to track PE-like returns. For example, the KraneShares Man Buyout Beta Index ETF (Ticker: BUYO) seeks to track the performance of the Man Buyout Beta Index. The index is designed to provide exposure to a subset of public equities that feature the key characteristics of companies held in PE/buyout funds. The Index employs a systematic approach to select a portfolio of small to mid-cap stocks from the Russell 2500 Index, targeting industries favored by PE firms as well as companies that are similar in size and display similar company-specific characteristics as those in traditional PE funds.

Constructing a PE-Like Portfolio

BUYO essentially “fishes in the same pond” as PE buyout firms by following these steps:

1. Focus on smaller and medium-sized companies (e.g., in the case of Liquid PE, those in the Russell 2500 Index)
2. Target industries favored by PE firms, such as Information Technology, Consumer Discretionary, Industrials, and Health Care
3. Screen for companies with strong free cash flow yield, higher operating margins, and top-line growth, along with a number of other PE-like characteristics
4. Consider factors like cash discipline and debt repayment ability

Capturing PE Return Drivers

Many of the fundamental characteristics of companies targeted for private equity takeouts, which are an important driver of buyout fund returns, are also found in select public companies. These include companies that are:

• Undervalued
• Growing
• Profitable
• Stable
• Efficient in managing their cash
• Operating in attractive industries
• Exposed to positive trends
• Able to take on debt

The Private Investment Space Is Slowing, Buyout Firms Are Sitting on Record Cash

Interestingly, buyout firms have seen their cash reserves grow consistently for many years. There are multiple reasons for this phenomenon: an insufficient number of attractively valued private investment opportunities, higher interest rates, and increased competition for deals. However, data has shown that buyout firms have been looking to publicly traded companies for new investment opportunities. There has been a noticeable uptick in buyout firms taking public companies private as a way to counter an insufficient number of attractively valued private investment opportunities.

Potential Advantages of Liquid PE Investing

• Intraday liquidity
• Lower management fees compared to traditional PE funds
• Full daily holdings transparency
• Potential for similar long-term returns as traditional PE
• Easier implementation of an endowment-like asset allocation strategy for many investors

Conclusion

Liquid private equity presents an innovative approach for investors seeking PE-like returns with greater accessibility and liquidity. By applying PE selection criteria to public equities, investors can potentially achieve return profiles similar to those of traditional PE funds while avoiding some of the drawbacks associated with illiquid investments.

As the PE industry continues to evolve and face challenges such as high cash levels and increased competition for deals, liquid PE strategies may become an increasingly attractive option for investors looking to potentially diversify their portfolios and capture some of the benefits typically associated with private equity investing.

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Diversification does not ensure a profit or guarantee against a loss.

For BUYO standard performance, top 10 holdings, risks, and other fund information, please click here.

Citations:

Data from Preqin Ltd as of 8/31/2024.