We provide a high level break down of how private credit returns and equity returns are achieved, the benefits of each and risks.
What is an equity investment?
Broadly speaking, equities also known as shares, represent an ownership in a company. This can be public, in the form of publicly traded shares such as those on the ASX or private, typically known as private equity.
Investors who hold equity are entitled to a portion of the business’s profits and voting rights in proportion to the stock percentage they hold and their respective share class holdings. Additionally, equity holders reap the benefits and risks of the business’s equity value appreciating or depreciating.
Unlike debt, equities sit at the bottom of the capital stack which means in the case of a business’s potential insolvency, equity investors are repaid last after all creditors. Furthermore, the share class an equity investor holds, will also determine their ranking in dividend payouts, and insolvency payouts.
Equity returns consist of dividends and capital growth.
What are dividends?
Dividends are a company’s profit that may or not may get paid to shareholders, subject to the financial performance of the business and the discretion of directors.
What is capital growth?
Investors that hold shares in a business, can benefit from increases in their respective share price as the value of the company they have invested in grows. Similarly, they can have a capital loss if the value of the business declines. This growth over months, years or decades also contributes to the total return of an equity investment.
A simple example is that if an investor were to purchase shares in a company at $10 and the price rose to $15 after 2 years, they would have achieved a 50% capital gain, or a annual increase of 25% per annum.
How are equity returns calculated?
The total return of equities is calculated by adding the capital growth / loss in the movement in share price, and dividends paid.
For example.
You may have purchased a share for $100.
After 1 year, the share price may have increased to $110.
The dividend payment for holding the share may be $5.
So your total return would be a capital growth of $10 plus a dividend of $5, equalling $15. In another words a 15% return on your initial investment.
Similarly, if you received a dividend of $5, but the share price dropped from $100 to $90, your net return would be negative $5, or a 5% loss for the year.
What are the risks of equity investments?
Unpredictive capital returns
While at face value equity investments can appear to be relatively simple and highly lucrative for investors, equity performances are heavily influenced by performance of the company, market sentiment, market speculation, sovereign risk (of country of operations), regulatory changes and demand for their underlying product or service and economic conditions.
Dividends are at the mercy of management
Assuming a company makes a profit within a given period. A company’s management has full autonomy when deciding how to best utilize profits.
Management may elect to distribute the full amount or a portion of the business’s profits to shareholders in the form of dividends. However, management are fully within their rights to reinvest profits back into the business or alternatively pay off debts.
Liquidity issues
It may be easy or hard to sell the shares of a business, subject to whether it is public or private. Private equity and small cap stocks that are listed, both have high liquidity risk. This effects the ability to exit an investment, and may mean a capital loss is incurred by the investor if there insufficient buyers.
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