Opinion – Grain in Grain: Even in a turbulent scenario, this equity investment strategy has attracted investors

Everyone knows that investing in stocks should have a long-term horizon. However, in the short term, the scenario of greater volatility in stocks and the rise in interest rates have driven investors away from stocks traded on the stock exchange. Meanwhile, another type of equity investment has gained interest from investors.

Investment in private shares, that is, those that are not traded on the stock exchange, has gained the attention of investors because it does not present the inherent volatility of investing on the stock exchange.

This investment is better known by its English name, Private Equity (FOOT).

In addition to lower volatility, investing in PE has another advantage, which is the greater potential for return than investing in stocks on the stock exchange.

But every bonus also has a cost, investments in PE have more risk and less liquidity. Additionally, this type of investment is still limited to qualified investors, that is, those who have more than BRL 1 million in financial resources.

As it is a new investment for most individual investors, there are still some definitions to be clarified. For example, some people confuse investing in PE with investing in smaller companies or small caps.

To explain all this, I interviewed XP Inc partner Lucas Brandão, responsible for the distribution of alternative funds at XP. I transcribe the interview below.

Can Private Equity Funds Be Compared to Small Caps Equity Funds?

The difference between the two is in the life stage of the company, that is, its maturity and, therefore, the earning potential. Private equity funds generally buy small, medium or large companies that are in a very rapid process of growth and consolidation. They are privately held companies, that is, they are not listed on the stock exchange. The manager works together with the company, injecting capital, creating value, helping to hire executives, networking, definition of strategic planning and processes. The objective of all this is to prepare the company to, in the future, sell it to a strategic investor, a local company, a larger multinational, or to make an IPO, that is, to launch the shares on the stock exchange. Small Caps equity funds buy publicly traded companies, that is, they potentially are buyers of companies sold by PE funds. Regarding the size of companies traded on the stock exchange, the target companies of small cap funds can be considered small (low liquidity), but even so, they are already mature companies. Each of the funds focuses on a different stage of the company’s lifecycle. Thus, the way to generate value is fundamentally different.

Why could he be more advantageous?

Mainly in Brazil, the great advantage of investing in PE funds is that the investment universe is much larger and full of opportunities than the stock exchange. The figure below, taken from publicity material from a PE fund, depicts this. While there are less than 400 companies traded on B3, there are thousands of companies in the country that can be targeted for investment. Additionally, there are many more equity fund managers than PE fund managers. Therefore, in addition to having an “aquarium” to fish more in PE companies, there are fewer people fishing, which increases the return potential. Additionally, you are not as subject to the volatility of the stock market, to the day to day of the stock market. We know how much the daily volatility causes anxiety to investors who end up selling their holdings at the worst times. Control over value creation is much more in the manager’s hands than in a stock fund, and here we are talking about investing in medium-sized companies to make them grow, the great success stories are in this niche.

What are the risks involved in investing in PE? Is it riskier than an equity fund?

We can list three main risks of investing in PE. The main risk is that of not finding the right investment thesis, of buying companies at high prices, not being able to generate value and not being able to make the divestment and sale within an attractive term and price. The second risk would be the fact that we are dealing with companies that are not yet mature. These naturally have more challenges than mature companies that are listed on the stock exchange. Therefore, they are riskier than investing, for example, in a share of a publicly traded company. Finally, a relevant risk that has to be considered is the liquidity risk. When investing in stocks, you have the option of pushing a button and selling your entire position, and within two business days the money is in your account. Investing in privately held companies, without a doubt, doesn’t work that way. You don’t get a buyer overnight. The purchase and sales negotiation processes are longer. When investing in PE funds, you must understand that you are in a long-term investment with low liquidity. In the case of the investment horizon, any investment in stock, whether on the stock exchange or private, should have a long-term horizon.

How is profitability given?

The return occurs with the manager’s efficiency in doing three activities: buying well, that is, with a valuation attractive, generate value to the asset, either through the organic growth of this company, or through inorganic growth (acquisitions) and, finally, sell well.

It could be said that it does not differ much from any investment in stocks. The difference is that in the case of PE investment, the manager collaborates in the company’s growth and value generation, in order to make the company achieve a better price for its shares.

Investors get their capital back as companies are sold. So this process of buying, generating value and selling is what brings the return to the investor.

Is a PE fund expected to earn more than an equity fund? Why? What examples?

Historically, the PE fund industry, especially the American one, where there is a greater history for valuation, has presented a performance of 5% to 10% per year superior to the stock market. In Brazil, we have less data available, but studies by the main entities of the segment show that here, too, the industry was more profitable than the stock exchange and than the Brazilian fixed income. The XP company is a successful Brazilian example of PE investment. The first PE fund injected R$100 million into the company in 2010, buying a major stake, nine years later the company went public in the US with a valuation of US$15.9 billion. Therefore, a multiplication of capital that is not seen in traditional investments.

Do I have the liquidity to exit at any time?

Investing in alternative funds is by nature a long-term investment. When you put your capital in this type of product, you have to have an investment horizon of up to 10 years, as this is the term of most funds. Often the fund starts to return capital much earlier, as it sells the portfolio companies, but even so, you have to invest thinking about 10 years. The only way out before the fund’s disinvestment deadline is through the process of assigning quotas in the secondary market, which is still very embryonic in Brazil. Some institutions, such as XP, are working on better equating the issue of illiquidity, but this is still a scene for the next chapters. Therefore, in alternative funds you give up liquidity in pursuit of higher return objectives.

Can everyone invest? What type of investor would this investment class be suitable for?

Unfortunately, investing in PE funds is not yet available to the general investor. However, there are already alternatives to serve part of the investors. Until not so long ago this was an investment intended only for billionaires and institutional investors. In 2020, XP started the process of democratizing this class, bringing the first fund intended for qualified investors in the market (investors with at least R$ 1 million in financial resources). Today we already have a very broad base and several products whose entry ticket starts in the range of R$ 25,000, which allows more Brazilians to access this investment option. However, the legislation still does not allow offering to the general public, but over time, we have no doubt that the legislation will evolve. It is important to remember that like any risky investment, it should not be objective for those more conservative investors.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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