The past two years have brought challenging times not only for the international stock exchanges but also for the whole private equity industry. Two-digit percentages of losses replaced the boom times in the late nineties. The burst of the tech bubble heralded an era of valuation reviews and portfolio adjustments.
As one of the leading European private equity advisors, Swiss Life Private Equity Partners has been faced with the same challenges as the industry. Swiss Life Private Equity Partners currently advises portfolios with total commitments in excess of E2.6bn in over 140 private equity funds and 50 direct investments world-wide. We have been in the industry for several years and have investments in a wide range of sectors, including those currently proving to be problematic. We’ve already seen a large shake-out in telecom and internet and are not too optimistic that all companies will survive. On the other hand, some companies are very well-positioned to take advantage of the next wave of development.

What are the lessons learned from this cyclical and partly exogenous caused downturn?
Private equity is a long-term business by nature. Investments into this asset class should always be considered accordingly. At the peak of the market boom, a few private equity funds, specifically venture capital funds, returned their committed capital within a year after closing. This has set some unrealistic benchmarks for the industry which led to a herd effect into booming and most promising industries such as internet and telecom. Valuations paid were often overpriced based on business plans with exorbitant growth rates and impractical exit assumptions. Basic caution and common sense in evaluating potential investments were sometimes missing.
With high growth rates and cash returns expected, some private equity funds invested nearly all of their committed capital with no reserves left for further rounds. Again, the long-term nature of our business requires equity partners which are in the position to support companies through different stages and industry cycles. In times of uncertainty, banks tend to question existing credit lines. The backing of the company’s equity partners then becomes essential. Swiss Life Private Equity Partners has seen companies of still high potential which had to be closed down due to short term liquidity problems and no backing by their equity partners.
The high returns realised in combination with the ‘J-curve’ effect of classic partnership investing led to quite aggressive overcommitment strategies at the limited partners’ level. But in contrast to the past, the actual situation in the private equity industry clearly shows longer holding periods and therefore a broadening of the ‘J-curve’. Private equity funds tend to pay back investments later and with lower returns. Despite the slower investment pace we see more and more limited partners with liquidity and asset allocation problems and partnerships with defaulting LP’s. The positive side effect is some promising secondary portfolios on the market.
The valuation principles, as developed by the industry associations, have been very useful for a long time. They are conservative and work satisfactorily in a more or less stable or growing market. However, they struggle to represent a true picture in a declining market or a market with significant structural shifts. Since this industry is becoming more and more institutionalised, the challenge facing market participants is clear: to respond to the investors’ needs with a revised set of standards whilst addressing the demand for transparency and adequate valuations.
Even more important than the lessons learned is to look forward and define the key success factors for investing in the future.
Diversification in private equity is key. At Swiss Life Private Equity Partners we place emphasis on building and maintaining a broadly diversified private equity portfolio. Through a disciplined asset allocation we ensure that we invest through different cycles and diversify by year, stage, sector and geography. As a European investor we slightly overweight European investments. However, we clearly follow a global approach with substantial exposure to the US market.
Swiss Life Private Equity Partners is very selective in making private equity investments. Not only do we know the market and the pipeline of managers coming to the market, but we also know the managers themselves as well as the intermediaries. In addition to referrals through our network we proactively look for a full investment funnel so that we are able to filter down to the best investment prospects.
We look at the performance and track record of the private equity manager very closely. In addition to pure financial analysis, we visit the managers, go through the investment memos, discuss investment rationales and talk to them about the development process. This helps us to evaluate how they have worked with portfolio companies, the management teams, and the value they have added to the enterprises. These findings are secured by checks with the CEO and CFO of the corresponding portfolio companies.
The composition and experience of the management team is another critical element in our evaluation process. The management has to have worked together for a longer period and successfully passed through different industry cycles. Consistency within the team is therefore key and strongly related to broadly shared incentive plans which have to meet market standards.
The investment case and strategy of a private equity manager is also essential for our investment decision. Beside the imperative fit to our asset allocation needs the manager has to substantiate consistency and transparency in implementing his strategy. The private equity manager has usually built up specific expertise, skill sets and competence within his investment field and he should focus accordingly. Even if this sounds obvious, we have seen managers changing their strategy too opportunistically and often failing later.
The size of the fund is another factor. A fund may have an excellent strategy and experienced employees but potentially its current or envisaged size is not in line with earlier raised funds. Swiss Life Private Equity Partners has seen previously small funds, particularly in the US, raising billion-dollar funds. These funds now experience difficulty in readjusting to the scale and the scope of capital deployment this entails. There is all too often little or no convincing economic rationale for raising funds that size, especially now that company valuations have come down.
In this context we are also questioning the development of fund conditions over the last years before the downturn. Parallel to the outstanding growth of returns of some funds we have seen an increase in carry and management fees of less experienced funds. Short term superb track records and expected future extrapolation blinded some private equity investors and led them to accept these conditions. The current fund-raising climate and the industry's expectation of a return to a somewhat 'normal' investment pace and IRRs lead to the rebalancing and validation of long-standing and proven market conditions.
In the future of the private equity industry we will see on the one side much larger, global firms with institutionalised processes serving clients on a global base which will absorb most money allocated to private equity. On the other side there will always be room for smaller funds which specialise in a particular niche, some of which will generate outstanding results. The size of a firm is not a precondition for the level of returns that it can generate.
The current market situation offers interesting investment opportunities. Swiss Life Private Equity Partners is very confident of benefiting from the market situation. The experience we have gained over the past years has been substantial. Our investment scope is global and we offer our clients a variety of standard and tailor-made solutions.
The private equity industry is evolving in the right direction. The market adjustment we are going through, even if sometimes painful, will lead to a healthy and robust base for long-term growth and recognition within the asset management community. The market is maturing and becoming much more commoditised. This is also reflected in the increasing asset allocation to Private Equity, even if European asset managers still have to catch up compared to their US peers.
Alexander Pfeifer is a partner at Swiss Life Private Equity Partners Ltd in Zurich

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