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Following the technology downturn, traditional old economy investments have come back into vogue. Whereas two or three years ago investors were willing to speculate on dot.com start-ups, fund managers now look at cash flow and profit capability.
“Traditional old economy has been the cornerstone of private equity performance over the last 15 years and I think they will carry on being so,” says Simon Wildig, a partner at Close Brothers Private Equity. Over the course of fund raising for his latest fund, Wildig says it has been encouraging to see that investors still focus on old economy stocks, which have less risk, albeit not offering the ‘spectacular returns’ which some of the more specialist funds achieved. In the UK, and possibly in Europe, he believes growth sectors are likely to be leisure, outsourced services and probably technology. Technology, he asserts, will come back, if cash flow and visibility of profits are available. Then there will be a “resurgence” in technology investing.
There is currently a lot of indigestion following the huge amount of money that was raised and invested in technology and early stage investments during 1999 and 2000. MTI, a UK venture capital firm, which focuses specifically on the early stage, high technology area in the UK, enjoyed progressively stronger returns for several years up to the end of 2001. The figures for 2001, and perhaps also for 2002, will show a fairly significant decline because of the bottoming-out in the high tech industry. The downturn is even more pronounced in the US, says Paul Castle, chief executive of MTI. “There, the mood is one of abject depression.”
According to PricewaterhouseCoopers’ MoneyTree survey for the third quarter of 2001, equity investment in venture-backed start-ups in the US fell 23% to $6.5bn (E7.4bn). But, Tracy Lefteroff, global managing partner of the venture capital practice of the firm, says that making comparisons to the “watershed” years of 1999 and 2000 is unrealistic. She expects the full year 2001 to reach $30bn, making it the third largest year in US history.
In spite of the fall in the market, good quality early stage, high technology investments, managed by specialists, are still being considered. MTI is still investing in high tech, early stage companies applying the same investment criteria it has always used – which includes good quality technology and intellectual property in sectors that have a good commercial future. “We are tending to be slightly more cautious but essentially our processes and investment criteria have remained unchanged. We believe the UK still represents excellent opportunity, as the quality of the technology tends to be world class,” explains Castle.
Pension funds investing in private equity should match their assets and liabilities before deciding upon their private equity investment, says Graham Sturrock, head of investment and mezzanine at Bank of Scotland. If they commit money for five years and have a five-year extended term, it could be 10 years before they see the last of their money. “In private equity it is very important people understand what they are investing for so they don’t get upset if the cash does not come in the near future,” he says. This means that they have to match their requirements with the type of investments they are making. “If they are going for quick investment return they would probably go for early stage or technology, whereas those who want cash over the long term should go for the buyout sector.”
Another consideration is geographic spread. Investors may wish to go for a globally balanced approach, which means pursuing investments in the US, Europe and the Far East, or just staying close to the domestic front. Investors must also establish the type and number of fund managers they need. As Sturrock points out: “Different managers have different strategies; some invest in a small number of highly managed investments and others will manage a much larger spread portfolio. If you have spread you have lower risk but less volatile returns.”
There is too the option of co-investing in an investee company, which many large investors tend to do, giving them the opportunity to pick good direct investments alongside their manager.
No matter what route an investor may take, it is worth noting that of those investee companies which are successfully realised, about half will be trade sales and half floatations. And, warns Castle: “You ought to budget for a failure rate of about 25%.”
Castle says that in order to build sound portfolio investors need to acquire a spread of top class fund managers across the various stages of private equity. “Ideally, pension funds should invest in between three to six private equity funds.” He believes that investors can achieve a return of a few hundred basis points above the FTSE all share index total return. Sturrock offers a more precise view that investors can expect a return of 15-17% net of fees in the long-term buyout sector.
Castle believes the industry is close to the bottom of a cycle, making it a good time to invest. “When the cycle starts to swing up again the market for floatations and trade sales will improve and returns will reflect excellent value,” he asserts. One major global fund of fund investor says that one of the best times to invest is during a recessionary period, when valuations have come down considerably compared to two years ago. “You are investing low and coming
out high. Hopefully in four or five years when you come to do an exit the markets will be up.”

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