US funds trigger market rush
The US success story has been a staggering one. Last year a record $85bn (E77.3bn) was raised in private equity funds in the US compared to $57bn in 1997. To put this in perspective, just E80bn has been raised across the whole of Europe over the past 12 years, according to EVCA figures. And the US pension plan community has no intention of curbing the tidal wave of assets it has created, which continues to head straight for the market.
The single most important factor which ignited the US private equity (PE) explosion and maintained its astonishing momentum has been information. In the late 1980s, a handful of firms such as Venture Economics and Cambridge Associates began to publish annual benchmark and performance information on around 50% of the general partnerships. This information proved to be a major turning point. “The fact that the industry performance data started to be assimilated and distributed was I think a major event for the US PE industry,” says Doug Brown, CEO and president at Advent International. “As it allowed investors to look at the asset class and try to determine was US PE performing better than public equity, better than bonds, worse than fixed income and start to compare the performance of the asset class as a whole over other asset classes.” This set of information also helped existing investors in PE to measure how their funds were faring with competing partnerships. It formalised PE as an asset class.
Today, PE allocations by US pension funds range from between 5% to 10% of their portfolios. The performance figures have been impressive. The 10-year internal rate of return (IRR) for US venture funds stands at 20%, with US buy-out funds at 18% and European PE at 14%. Over five years these figures get even better. For US venture, returns have peaked at 35%, Europe at 29% and US buy out at 24%. The last five years have proved very successful for US investors mainly down to the performance of the US IPO market and have continued to encourage invest-ors to keep on coming in. Not surprisingly, in light of these statistics many US pension plans’ PE allocations now far eclipse those to real estate. A case in point is the $52.6bn IBM pension fund which has combined its PE and real estate investments into a single operation and is now around two thirds dominated by the former asset class.
The $46.5bn Pennsylvania Public School Employees’ Retirement System invests 5% of its assets across all types of PE both domestically and internationally. “We have long term liabilities and the returns are in excess of the public markets over time and that’s why we do it,” says John Wayne, PE investments. The $33bn Virginia Retirement Scheme invests $3.4bn to over 120 PE funds and its returns of 24.3% per annum have beaten the scheme’s benchmark, a broad US public equity index, by 1.3%. “We believe that we can build a PE programme that over the long term will exceed that of the public equity market,” says Marcus Simpson at the fund. “We were very fortunate to start at the right time and as long as we can outperform the public market, that will be the basis to keep investing.”
The $87bn General Motors (GM) plan invests a staggering $4.5bn of its assets across all areas of private equity, around 80-100 holdings, and continues to invest new money at a rate of $500m per year. The plan has been active in the area since the early 1980s. “We have been in all aspects,” says Jack Miller, vice president business development at GMIM in New York. “Being a large player we have felt that we wanted to be exposed to all the areas within that.” With its 3-5 year IRRs currently standing at 28-35%, it is an investment they are obviously pleased they have made. “We do believe it is a wonderful diversifier and a large plan such as we have really has an opportunity to take advantage of diversifying our risk and enhancing our return.”
One of the major factors which has fuelled the growth in the US market but has also left investors hungry for more, has been the success stories of the internet companies. But the growth of the industry has left investors and fund managers alike concerned that is becoming oversubscribed. Newcomers into the US market are finding it difficult to access funds being raised as existing clients are meeting a large proportion of the commitments, so they are being forced to look elsewhere. Hicks Muse, one of the major US houses recently closed a fund at $4.1bn. On the day it started marketing it had already obtained $2.8bn in commitments – sourced from their existing clients. Hence the next port of call for investors who have wet their appetites back home, looks like being the EU, an economy boasting a combined GDP matching if not exceeding the US market, and promising plenty of growth for those investors willing to come in. Cambridge Associates and Venture Economics now have European benchmarks, which has helped spur on the market further. “There are expectations that the arrival of the euro is going to improve the competitiveness of European companies, and the speculation is that European companies have better growth prospects than some of their US counterparts,” says Advent’s Brown.
Larry Urnheim at JP Morgan Inv-estment Management in New York, which manages the PE allocation of the AT&T pension fund, supports this view. “There is clearly an appetite to invest in PE outside of the US,” he says adding “And most of that has gone to Western Europe.” Historically GM’s exposure has been to the US market with around 10% allocated to international private equity, and the plan’s strategy is to expand it to the 25% mark. “International is of increasing importance to us,” says GM’s Miller.
The element of risk control has been a factor which has deterred many European investors less familiar with the PE market, but for their US counterparts, the concern is less prominent and is controlled in the early stages of research into the general partnerships. As JP Morgan’s Urnheim points out “Unless you want to be in US treasuries, there are no guarantees.” He adds: “One needs to be cognisant in the understanding of the risks.”
“In our partnerships we require a subordination so we are protecting our capital but I think historically if you look, you do get your money back, there’s not a lot of big losers out there,” says Wayne at the Pennsylvania Public School Employees’ Retirement System. He feels that the track record is very important and the terms of agreement should be brought carefully into consideration before any commitments have been made. However, while many investors in Europe might target the large end of the market for their initial investments, in terms of cost and risk, Wayne believes that the mid-market can often be the best bet. “I would rather do middle market personally. In large buy outs you are typically buying into publicly held companies or some distressed company, then you have to take a huge company and turn it around. In the middle market, they are not public yet, so you can bring your expertise in depending on what your team is and then have an exit strategy which includes the public market action.”
GM’s Miller sees the usage of consultants and the existence of fund of funds as imperative in this process at least for first time investors, hence taking a large proportion of the due diligence procedures out of the plan’s hands. “Especially for early players, it is a good way to become familiar with the range of funds and investments out there,” he says.
In the US there has been a considerable growth of funds of funds though he warns in this latter area that invest-ors should be aware of how skilled the managers actually are and how long they have been in the market as there are plenty of ‘rookies’ coming in to the marketplace for the first time with impressive ideas and boundless en-thusiasm, and for first time investors, entrusting their assets to these sorts of managers may not be the best ap-proach. “A number of the newer ones are too young to show you what they have achieved and I think people should bear this in mind.”