At the recent Luxembourg for Finance anniversary, Prime Minister Bettel stated that “The financial sector should be proud"1.
This quote serves as a reminder of the positive impact private equity has on the financial sector (particularly funds), the economy and society as a whole. With this in mind, what is private equity’s role in economic growth?
What is private equity?
Private equity (PE) is a form of investment where managers (i.e., PE houses) buy (parts of) companies with growth potential, bringing their expertise and financing to boost the development of these companies, and sell them within the horizon of four to six years.
The companies can either be mature companies or younger ones (usually then focusing on more specific innovation). All sectors of our day-to-day life are covered: from health to all types of industrial companies, from tech to agriculture and from food and energy to communication and transportation.
When investing in mature companies, it could either be through a majority stake, with the view to take control and implement a new strategy, or through a significant minority shareholding, gaining specific governance rights while at the same time giving those companies the capital and power to expand their development.
The pace of these investments has continuously grown across the globe, with total investment reaching USD 600 billion in 2000, USD 4.4 trillion 20 years later, and the anticipation that it will exceed USD 9 trillion by 20252.
How does private equity impact the economy, innovation and job creation?
PE firms do not simply sit back and observe the management of companies they invest in. Rather, they actively participate in management and work to implement enhanced strategies that add value, drive growth and improve financial performance. This approach not only benefits the companies themselves, but also positively impacts the overall economy, innovation and job creation: indeed, by bringing expertise and resources to the companies they invest in, PE houses help said companies improve their operations, increase efficiency, save costs and therefore become more competitive and create jobs.
The positive influence of private equity can be encapsulated by six key pillars:
Innovation: Start-ups and SMEs, especially those active in the technology and digital industries, are the innovation and growth engine of the European – and even worldwide – economy. By offering the financing and assistance needed to enable companies to realize their full potential – by focusing on skill development, training and mentorship in order to boost creativity – PE investments directly contribute to the innovation capacity of our economy.
Today, it is estimated that 25,000 companies in Europe are backed by private equity, with 17,800 of these being SMEs3.
Talent: The primary influence of PE is likely to be seen in the realm of employment. The employment rate is a key indicator of the health of an economy, and creating jobs is crucial for the wellbeing of society. PE firms invest in companies to promote growth, which in turn leads to job creation. In fact, a recent study from Invest Europe4 showed that PE-owned companies in Europe created 103 566 jobs in 2020, corresponding to a net increase of 2%, while the European job market, as a whole, contracted by 1,6%. Furthermore, today, PE-owned companies employ 10 million people in Europe, representing more than 4,3% of the total workforce.
Increased capital access: Private equity firms typically have access to large amounts of capital (also known as “dry powder”) that might otherwise be unavailable from conventional sources, such as banks, that they can use to finance businesses. This is particularly critical for smaller businesses or those in fields which are considered risky by conventional investors.
Additionally, PE firms are less strict than banks in terms of repayment terms or covenants, and provide companies more flexibility to cash back their investments, which is extremely welcomed by companies in launching phase.
Infrastructure development: All over the world, keeping pace with demographic changes and the expectations and behaviours of citizens has become increasingly challenging. Linked to this, governments face growing difficulties to finance the construction or maintenance of infrastructure projects aligned with demographic/citizen trends. More and more, we see private equity companies partner with governments to build and develop critical infrastructure assets, such as roads, airports, utilities, as well as infrastructure which encourages sustainability – the latter a reflection of how PE can direct capital to positively impact societies.
Social impact: PE firms are playing a growing role as a facilitator for sustainable investments, responding to ESG (environmental, social and governance) criteria. They push the companies they invest in to adopt socially responsible behaviors, and also provide resources and expertise to businesses seeking climate change solutions and firms focusing on increasing access to healthcare and education in marginalized regions.
To illustrate this ESG trend and success, as at the end of 2020, sustainable investment products accounted for 11% of total net assets domiciled in Europe, more than doubling in net assets since 2018. In 2020, sustainable funds also attracted over half of the net new money invested in the investment fund market5.
Financial performance: While not all PE funds are profitable (a recurring figure suggests that between 83 and 90% are profitable), data analysis and studies have shown that the investment performance of PE funds outperforms investment yields of listed companies over short, medium and long-term horizons. Indeed, the average internal rate of return for PE investments is, when looking at historical data – 30 years of PE existence – for Europe, around 15% when the overall economy was around 6-7%6. This outperformance is even bigger when looking at more recent years, probably driven by the growing experience and expertise of PE managers.
The success story of Luxembourg as a worldwide PE hub
If private equity has seen prosperous growth on a global level, Luxembourg has succeeded in establishing itself as a prominent global hub for the sector.
Today, according to the Luxembourg Private Equity and Venture Capital Association (LPEA), 90% of the European Private Equity and Venture Capital funds and 19 out of the 20 largest worldwide PE houses are conducting business out of Luxembourg, where the total assets under management exceeds EUR 500 billion7, and is projected to increase at an annual growth rate of 10%, driven in part by factors such as Brexit, monetary policy tightening in North America and Europe, and the anticipated growth of the younger Asian private equity market.
One of the main strengths of Luxembourg is undoubtedly its “business friendly” environment, with successive governments willing to protect, develop and enhance the attractiveness of the country.
This “business enabler commitment” from politics has provided the sector in Luxembourg with flexible and powerful tools necessary to structure itself in a very competitive way. This started with the SICAR regime introduced in 2004, soon completed with the SIF, the SCSp and the RAIF.
And today, all these structures have successfully contributed to the radiance of Luxembourg for PE: it is estimated that the sector has around 300 SICAR, 1,500 SIF, 2400 SCSp and 620 RAIF8.
This success story has also materialized in job creation and opportunities. Out of the 51,000 people working in the financial services industry, it is estimated that 8,000 are related to private equity. On top, it is also estimated that additional 1,400 jobs remain unfilled for the sector in Luxembourg9. Attracting skilled individuals is a continuous challenge, and providing support and a specialized training framework for the PE industry is necessary and will be paramount in helping fulfil new roles, such as those pertaining to fundraising and investor relations.
Lastly, PE in Luxembourg directly supports innovation, sustainable investments and start-ups. The government has placed a strong emphasis on innovation with, for instance, the creation of the Luxembourg House of Financial Technology (LHoFT), which serves as a Luxembourg’s fintech centre, and on sustainable investment with the launch of the Luxembourg Future Fund, which promotes sustainable development in key strategic sectors of Luxembourg’s economy. Private equity’s early involvement has been crucial in the success of many initiatives promoted by these organizations. A recent example of this success is the Luxembourg PE-backed medical booking application Doctena that has become a European leader and a flagship for Luxembourg’s start-up ecosystem.
In conclusion, private equity can sometimes been decried, but its positive impacts on the real economy and our day-to-day life cannot be denied, be it in terms of job creation, wealth creation, innovation and ESG. This is particularly true for Luxembourg, where PE’s weight in terms of jobs creation and motor of innovation is, proportionally, much heavier than our neighbouring countries.
Yet, private equity firms, investment funds, and portfolio companies encounter unprecedented challenges. They feel the need to invest capital in the midst of unparalleled economic and geopolitical instability, escalating competition, and growing stakeholder demands. Achieving prosperous deals is contingent upon their capacity to act swiftly, promote rapid and strategic expansion, and generate higher worth throughout the entire transaction process.
It is therefore key that the government continues to work hand-in-hand with all professional actors of the financial sector to ensure that Luxembourg remains at the competitive edge.