Great companies have the ability to consistently produce stable and durable cash flows — and to capitalize on secular growth trends over the long term. Yet many great businesses seeking longer-term capital today are not well served by the traditional public and private markets.
In the public markets, smaller companies often don’t get the level of research coverage and trade execution that large companies enjoy, resulting in less efficient access to capital. And in the private markets, private equity traditionally seeks a three- to five-year horizon — creating a mismatch for managements of established, well-run businesses focused on long-term value creation.
This is where long-term private equity (LTPE) comes in. LTPE is an emerging investment strategy that acquires great businesses with lower operating risk profiles. The types of assets well-suited to LTPE sit between traditional infrastructure and private equity on the risk/return spectrum (see Figure 1).
Investors holding these assets for 10 to 15 years may be able to achieve lower volatility and transaction costs and generate meaningful compounding returns while allowing management to focus on running their businesses. A longer horizon also allows these businesses to benefit from secular tailwinds, which are often more difficult to time correctly within a traditional private equity holding period.
A Growing Investible Universe for LTPE
Over 1,000 private companies across North America, Western Europe and Australia have been successively owned by at least three private equity owners. For some of these companies, an LTPE approach would have led to a longer-term focus, lower friction costs and fewer distractions versus selling from one private equity owner to another every few years.
Today there is also a vast and growing expanse of underserved public companies seeking long-term and patient capital. LTPE can be an attractive option for both public and private companies seeking partners that can look beyond quarterly results and are actively involved in governance and capital allocation aimed at achieving longer-term goals.
The Need for Long-Term Capital
Companies typically sought by traditional private equity tend to have attributes suited for a shorter investment horizon, including:
- Significant consolidation or deconsolidation
- Repositioning of the competitive or business model
- Rapidly changing market
- Meaningful operational changes
- Creating a stand-alone entity from an orphaned division
- Revitalizing a distressed company
In these situations, all stakeholders are focused on a medium-term outcome with incentives and governance aligned to it, including a planned exit of the investment.
Conversely, businesses with attributes suitable for LTPE investing usually do not need to transform or reposition and have demonstrated a track record of durability (see Figure 2). Often, management teams are seeking patient and long-term capital to support their efforts to deliver consistent and attractive returns. These companies may prefer not to go public or be sold either to a strategic acquirer or from one private equity firm to another. Importantly, sale processes and ownership changes can be significant distractions and can diminish business performance.
Investing in LTPE
An LTPE strategy can be attractive for investors seeking exposure to exceptional and durable businesses with limited volatility from uncontrollable factors. LTPE’s longer-term investment horizon also minimizes friction costs and can capture incremental value from secular tailwinds.
A cornerstone of LTPE investing is employing rigorous standards in identifying a high-quality business with characteristics that minimize exogenous risks and deliver greater operational stability (see Figure 3). Market-leading businesses providing essential products and services with stable cash flows and long-term value creation potential are ideal candidates given their durable and defensible market positions, with limited risk of substitution or disruption.
They also demonstrate highly consistent profitability and cash flow conversion through market cycles, with strong returns on capital. Finally, these businesses usually have exceptional management teams with proven records of sustainable shareholder returns. They tend to focus on continuous improvement and reinvesting capital into projects with the potential to generate attractive absolute returns, while responsibly distributing excess cash to investors.
Business quality is especially important during periods of market and interest rate volatility. Exceptional companies see a greater proportion of their long-term value creation potential generated through the realization of stable, compounding growth and free cash flow generation — factors that are more reliant on underlying business attributes. Therefore, LTPE investments should be much less susceptible to exogenous factors such as:
- Changes in the exit multiple realized upon a sale
- Availability or cost of debt, which is contingent on the state of capital markets
- Unforeseen recessions
LTPE’s lower risk profile targets lower gross returns than traditional private equity, but LTPE can deliver comparable net returns to investors through less fees and friction costs:
- Deal Friction: Not having to sell companies every few years allows investments in an LTPE structure to avoid incurring meaningful buy-side and sell-side advisor, financing and other fees. These businesses can instead pay reoccurring dividends or be responsibly recapitalized to return capital to investors.
- Investor Fees: LTPE strategies can offer lower management and incentive fees compared with traditional private equity. And because identifying LTPE opportunities tends to be more episodic, fees are typically incurred on invested rather than committed capital.
Importantly, LTPE’s longer horizon lets investors keep their capital invested and compounding on a pre-tax/pre-fee basis. And they don’t need to take reinvestment risk or sit on cash until they find a suitable alternative investment.
The Virtue of Patience
Exceptional companies are increasingly seeking LTPE capital because of the long-term partnership and alignment it affords. And investors are increasingly allocating to LTPE to gain exposure to higher-quality, lower-risk companies that are well equipped to capitalize on long-term secular tailwinds.
The bottom line: Combining a long-term focus with truly exceptional, low-risk companies has the potential to unlock the power of compounding returns.