Institutional investors are becoming ever more attracted by private equity, says Hugh Wheelan. But can consistency be found in such a complex field?
Private equity is in vogue. A glance at the expansion rates for the European market between 1993 and 1998, according to British Venture Capital Association (BVCA) figures, shows compound annual growth rates of 39% in the Netherlands, 34% in the UK, 29% in Scandinavia and 26% in Germany – with the growth pattern rising sharply from 1997.
Buoyed on a heady cocktail of strong returns, greater professionalisation of both investor base and companies – and the felling of shibboleths, the market is moving forward rapidly.
Certainly, private equity is no longer viewed by institutions as inherently more volatile than listed equity. Less correlated to markets and with longer periods of illiquidity – yes, but no more a taboo asset class.
The upshot for the private equity arena has been impressive – increasing fund sizes, the segmentation and specialisation of deals by stage and sector and a concentration of large buy-outs.
Similarly, the opening up of the European market and the arrival of US houses have pushed forward quality issues, further enhanced by improved performance data from the likes of the BVCA and European Private Equity Venture Capital Association (EVCA).
However, the market itself creates its own constraints. Investors are finding it increasingly difficult to access the best funds and conversely market players are seeking the most reliable partnerships.
The European market is still small fry though when compared to its US counterpart. Commitments in Europe between 1995 and 1998 were approximately $55bn (e55bn) against $200bn in the US, according to figures from placement agent Helix Associates in London.
This indicates ample room for further penetration.
A combination of factors is allowing these opportunities to be exploited.
Anglo-American style deals with the emphasis on auctions, financial engineering, use of high-yield debt instruments, management motivation and well-guided exits have sharpened up market practice.
EMU has played its part, too, with the abolition of trade barriers, tariffs and passport controls opening up the investment terrain.
Furthermore, as European companies have to move away from their domestic market, large corporate acquisitions have created the potential infrastructure for larger private equity deals.
The simultaneous growth in appetite for private equity within pension funds has been prompted by the illustrious returns available on some of these deals, alongside the realisation that a lack of available debt in European markets means equity portions have to sweat.
As Ian Armitage, chief executive at Mercury Private Equity in London, comments, the industry is beginning to accommodate private equity: “The trend over the last year is that the top 10 consultants in the UK have brought in private equity experts, where previously there were very few.
“In Europe it is a little more difficult because they are still few and far between.”
Nevertheless, the Continental European fixed-income to equity shift has also been accompanied by the implementation of private equity strategies.
Dutch, Swiss, Scandinavian and German pension funds and insurance companies are setting aggressive targets to substantially increase allocations to both quoted and private equity and regard the latter as a separate asset class.
Stefan Marelid, head of private equity at Stockholm-based SEB, comments: “Due to competitive forces no-one wants to be left behind in Scandinavia and a lot of Swedish institutions are gearing up to 5% allocation in private equity.
“Some have started using consultants to figure out an appropriate allocation. Those I have spoken to are getting more of a 10% reach. But 5% seems to be the cautious level.”
Marelid says such allocations can not be wholly invested in the Scandinavian market and institutions are looking to Europe first for geographic reasons and then the US. “As institutions become more competent they are likely to look at country funds or at venture capital in the US, which has been the hot ticket lately.”
While France, Italy and Spain still tend to have the lowest allocations and least expertise in the market, the euro is negating paternal state influence and markets are becoming institutionalised.
Bruno Raschle, managing director at Zurich-based private equity fund of fund manager Advisers On Private Equity, comments: “Funds are realising that if they don’t do private equity today they won’t get access tomorrow and they are increasing allocations by as much as they can as fast as they can”.
Figures collated by Mercury, however, show the discrepancies remaining in European private equity investment as a percentage of GDP, with the UK showing a ratio of 0.33%, Scandinavia (0.13%), Netherlands (0.18%) France (0.07%) Italy (0.05%) and Germany (0.04%).
For the US players, viewing Europe as a less competitive opportunity than their domestic market – particularly while returns in the US are under pressure, the consensus is that it will take time to develop the right approach, although reputations and track records will undoubtedly help.
John Barber, at placement agents Helix Associates, believes the US firms currently have three advantages though, albeit with short half-lives as Europe develops. “Firstly, they have been dealing in bull market conditions for a long time, so they are used to negotiating in high priced markets. Secondly, they have highly developed strategies such as sector specific, and thirdly they are used to dealing with the bigger numbers. I think their presence is a good thing for the market.”
On the whole, private equity firms – albeit predominantly US and UK based – are adopting a pan-European mentality, expanding cross-border and hiring local teams.
David Currie, managing director (private equity) at Edinburgh-based Standard Life Investment Management, says the European trail of the US bigger buy-out funds is continuing.
“The impact is that there is definitely more competition at the top end of the market and more deals being done. European fund managers are jumping ship because the US firms can buy-out their contracts and are also paying significant signing on fees.”
Barber says the private equity market can be split into four tiers. “It is impossible to gain access to the US top tier funds, which are reinvested via existing customers – although you can take a small stake with the likes of HarbourVest in the US. “For the lesser known US, European and Israeli funds there is access for well developed funds and for the lower profile venture and tech firms you can get in. The large pan-European funds, however, will take all-comers and a fund we are involved in recently raised e3bn with no access problems.”
The intensifying competition in the domain of large buy-outs – previously the mainstay of the market, accounting for around 80% of transactions – is obliging investors to shop around. And suggestions are that 2000 may be a lull period for the European buy-out market, as Christian Dummett, head of private equity at Abbey National, in London, comments: “In 1998/99 most of our buy-out capital went to Europe where there were good quality funds available.
“This year only one or two funds have excited us relative to the opportunities we are seeing in the US. I think some of the larger European funds will be back next year though.”
Barber suggests the European focus is now on sector and ‘angled’ venture teams, where he says a lot of capital is being raised, but a lot invested, too.
Other players are going more exotic – adding tiers of debt through the credit markets or seeking financial backing from the US. The complexity of large deals and weakening returns has enabled single region operators focusing on small to mid cap buy-outs to flourish.
However, the increasing popularity of these funds is pushing transactions into the top bracket and increasing deal prices.
Currie at Standard Life says a definite trend is the increasing emphasis on tech funds and the venture stage of the private equity cycle. “There is a resurgence of interest in venture and technology despite the small number of well established managers. A number of new ones are spawning, though – noticeably venture funds coming from US backgrounds, which is encouraging because they have a more global view and a different mindset. The trend is being driven by internet enthusiasm and the possibility of good returns if done properly.
“Growth has tended to be the favoured style with investors looking for tech funds with fast growth potential.”
Armitage at Mercury adds: “The success of technology funds in the US has been staggering, with raised funds invested in 12 months and then returned. We expect to see the rise in technology performance come over here.”
He notes that the business is currently split between investment banks and independent players in Europe. “In the US it is almost exclusively independents and Europe is expected to follow that model.”
Seed and start-up are the biggest growth sectors, though – driven in part by junior markets like the UK’s AIM, Germany’s Neuer Markt and Brussels based Easdaq, where there is a growing amount of European IPO interest and initial listings.
Currie says interest is Europe-wide, but adds: “Southern Europe is particularly busy at present. There are some good signs in France and a lot of action in Germany, particularly prompted by the Neuer Markt where there were around150 new issues last year.”
Such change to the market, however, has not removed domestic idiosyncrasies from the fray. Scandinavians still tend to deal in their domestic markets buying company spin-offs.
Similarly, in Italy, privately owned business packages form the bulk of transactions and in the UK large MBOs still rule the roost.
Marelid, at SEB, notes: “The local effect still exists, in part because terms and conditions are not standardised as in the US. We spend a lot of time negotiating these terms rather than concentrating on teams.”
The large European deals are diluting these effects, although capital is still less obvious and accessible than in the US.
Deals continue to be best sourced at a local level where language, interest rates and banking practices do not differ considerably. This means private equity strategies need to be tailored for different markets making investment harder and less lucrative than in the US. Development is imminent here, though – considering the stakes.
As Marelid, point outs: “In my view, the European market is probably the most attractive in the world – from a risk adjusted point of view.”
Meanwhile, the debate over direct or indirect, discretionary or fund of funds for private equity investment continues. Barber says the investment route depends largely on the size of the pension fund allocation. “The BVCA says funds with less than £100m in private equity should go via fund of funds due to the capital preservation in diversification across funds and the fact it is hands free.”
He says middle market exposure or niche approaches should be through fund of funds, with liquidity possibilities on offer through quoted vehicles.
Armitage, at Mercury, believes the single manager approach can be more appropriate.
“With fund of funds you are exposed to a lot less liquidity with an extra layer of fees and averaged returns. There is also no active secondary market fund of funds. People might want to get out of deals and this can be easier to do through a single manager arrangement. The fiduciary interest is that if you don’t want to select a manager – you buy the brand to do this. “
Bruno Raschle, at Advisers On Private Equity, comments: “Direct private equity is difficult and time consuming because this is still a relationship business. Also, institutions need to have a manager for 10 years or more.”
He also sees a conflict of interest in discretionary mandates: “As a fund of funds manager we have to fight for a few million extra in assets. How do you allocate this if you have discretionary accounts? Over time I would say the only way to handle this is fund of funds – the discretionary route will be the exception.
Raschle also voices concern over the proliferation of managers in the market. “My concern is that there are so many players out there without a clue as to how fast the world is changing, due to the IT revolution and new business models. Risk profiles on portfolios are changing. Some 90% of today’s players have never managed a portfolio in an economic downturn.
“If something changes in the capital markets, then many of the institutions invested in private equity don’t have the structures and the processes to deal with that. Suddenly, they have an overexposure to private equity, requiring them to divest and many will withdraw from the market. This will affect even the good players, so the selection of limited partners is crucial. Many institutions don’t realise that.”
Currie, at Standard Life, adds: “For institutional investors, time commitment and monitoring of private equity is difficult. It’s not something you can dip into every three to four years.
“There is an extra layer of fees in fund of funds, but it is no more expensive than going alone.”
The search is on then for consistency in a field that is becoming ever more complex. There is no doubt that the European private equity market is developing apace, and while all agree that the best returns will come from stable teams with proven records and which are hungry and adaptable to market change – as with anything in ‘vogue’ – not everyone will get the real deal and the uninitiated could end up looking foolish if they’re not careful.