Taking away the disadvantages
Stéphanie Bilo and Urs Wietlisbach look at Princess, Partners Group’s new investment company, and the way private equity asset management is being reinvented
The task, given by our clients, was clear: to create a product that allows us to invest in the attractive asset class of private equity which at the same time takes away the disadvantages in investing in it.
In general, access to this asset class is hindered by high minimum investment requirements, difficult entry to sought-after partnerships, lack of liquidity and long lock-up periods. In addition, this product should also attract investors who are unwilling or not allowed to bear (private) equity risk since in many continental European countries institutions, such as pension funds, are not allowed by regulation to invest in this interesting asset class.
To sum it up: investing in private equity and not bearing any private equity risk – this is basically the concept behind Princess Private Equity Holding Limited, a Guernsey-based private equity investment company formed by Partners Group and Swiss Re.
Through its Luxembourg Stock Exchange listed zero coupon convertible bond (AAAr-rated by Standard & Poor’s), Princess provides institutional as well as private investors the opportunity to invest in the asset class of venture capital/private equity while having the par value of the bond protected at maturity under insurance arrangements reinsured by Swiss Re. Furthermore, most regulatory bodies allow institutions to account for the Princess product as a bond position.
Throughout the process of developing Princess it became clear that private equity is not only attractive, but also a complex asset class which should be managed with a specific and sophisticated private equity approach. Knowing exactly the kind of risks we are exposed to was essential. Therefore, we have devoted considerable effort to developing various models which are part of our top-down approach.
One of these models – the private equity risk/return model – is created on the basis of historical worldwide private equity data, some of which dates back to1969. It enables us to quantify and optimise private equity risk and return. But most importantly, we can now find efficient portfolio combinations. Our strategic asset allocation in private equity, such as that in Princess, is characterised by broad diversification. Compared to public equity, diversification is not only achieved through geographic regions, but also through the array of private equity investment styles (early and later stage venture, small, mid-size and large buyout, or special situations) and vintage years (defined by the year in which new funds are launched) as well as fund size.
The model indicates that the expected annual return on investment of Princess is approximately 12–15%, a reasonably impressive income compared with AAA-rated fixed-income products. The graph illustrates the fact that while bearing a similar risk as bonds, the expected return is significantly higher with Princess. When compared to top quartile private equity returns, the Princess return is marginally less, which is due solely to the reinsurance premium. According to our calculations, in the case of the top quartile funds, there is a 97% chance (84% in case of average funds) that returns from Princess will be above 6% per year, an approximation of the opportunity costs of the investment if a bondholder would otherwise have invested in US treasuries.
The overcommitment model represents another powerful tool to structure private equity products. We use it for Princess in an effort to maximise returns. On the basis of statistical data from Venture Economics it can be shown that investments in private equity funds have a peak level of investment of 65%, while leaving the remainder of the committed capital invested in short-term instruments. This is due to the fact that the amount committed is not entirely drawn down until a few years later, however prior to this distributions have already begun.
With the uncertainty of the investment pattern a fund manager usually can never be sure of which percentage of the total strategic asset allocation is truly invested in private equity. However, with the overcommitment approach applied to Princess an investor can be sure of full investment in private equity over time as soon as the full investment level is achieved.
Moreover, the resulting opportunity cost dilutes the overall performance for the investor from private equity investments by approximately one third. We have created an overcommitment strategy using cash flow forecasting and monitoring models. This approach, after an initial build-up phase, will result in higher investment returns because a full investment level should be achieved in a shorter period and be sustained over time, and therefore
eliminate the opportunity costs.
For Princess we estimate that a full investment level will be reached in approximately two years. To date, Princess has already made commitments of more than $600m(e600m) to over 50 attractive partnerships worldwide.
We believe the asset class of private equity will further gain in importance. Since high expected return for relatively marginal risk and low correlation with traditional asset classes are very appealing characteristics to investors of private equity, this asset class will find a fixed portion of allocation even in conservative portfolios.
Stéphanie Bilo is a financial analyst and Urs Wietlisbach is a managing partner with Partners Group inZug
Partners Group was established in 1996 by three entrepreneurial bankers emanating from Goldman Sachs & Co.
Today Partners Group includes over 50 people in Zug, Frankfurt, New York and Guernsey, six of whom are managing partners sharing the ownership of the company. Partners Group is organised in four integrated and interdependent business units: Private Equity Asset Management, Direct Investments & Advisory, Marketing/Structuring, and Wealth Management.
Partners Group offers the full range of private equity investing and has gained wide industry recognition because of its innovative approach in structuring and managing private equity products such as Castle Private Equity and the Princess Private Equity Holding.