Venture into the undiscovered
The attractions of the private equity market are undeniable. Returns by top tier private equity funds can far exceed those of already well performing stock portfolios, and if you believe the ‘euro ignites entrpreneurial spirit’ argument, then the investment opportunities in Europe are pretty damn good as well.
The results of the IPE’s European private equity group survey (pages 54/55) indicate that the market has never had it so good. In the next two years managers surveyed want to pull in E16bn and over the next two to five years, they reckon they can raise E25bn in European assets. Bearing in mind that not all managers surveyed replied to this part of the survey, the real potential amount which managers are aiming for must far eclipse this figure.
But are they being too optimistic? While investors appreciate the benefits a private equity allocation could potentially bring to their portfolio, they have been traditionally put off by the illiquidity, the long lock-up periods, the lack of substantial track records offered by managers, and the equal lack of publicly held information available on the asset class. Furthermore, many funds who dabbled in the market in the mid to late 1980s got their fingers seriously burnt and pulled out of the market. It has been a long and arduous road ever since to get them back in.
With anything worth having in the investment markets there are going to be elements of risk involved. There are substantial elements of risk attached to the emerging markets, particularly in recent times and many in the industry cannot understand why pension funds are prepared to remain happily invested in this asset class while continuing to steer well clear of private equity. Looking at the returns in this market, it is not unreasonable for a pension fund to expect around 3-4% over and above its traditional stock portfolio, and US funds have been enjoying returns from upper quartile performers in the 20-35% region for some years (see page xx) and are continuing to up their allocations because of this. As Harry Olimann at advisers Altius Associates states simply: “You are talking about the most imperfect market in the world and in an imperfect market you make a premium.”
For those investors who have invested in the private equity markets, typically they have treated the asset class as having risk characteristics comparable with equity, though with a longer illiquidity profile. And the low levels of correlation with the public equity markets fuel the advocates’ arguments that private equity if anything stabilises a portfolio as opposed to making it riskier. “Some more sophisticated investors have looked at the efficient frontier analysis and have found that in spite of the risk that you might intuitively believe might exist, the private equity component favourably shifts the overall portfolio risk and return characteristics,” says Patrick Cook at venture capital firm 3i in London.
“The whole risk issue is really an odd one in private equity,” furthers Simon Thornton of BC Partners in London. “What do you mean by risk? If you look at the total universe of private equity funds in Europe there are very few that have actually lost money.”
He continues: “On a portfolio of buy out investments you wouldn’t expect to lose money on very many of them. If you take 10 investments you would probably make good returns on three or four, OK returns on three or four, and lose some or all of your money on a couple of them. Whereas on a venture portfolio, you would lose money on four or five, you would make medium returns on two or three and then you would have one or two where you make really good returns as in 20 or 30 times your money and that pays for the rest of the portfolio.”
However there can be huge spreads in different funds’ performances and these types of returns can only be found in the upper quartiles. According to Goldman Sachs estimates, only 10-20% of private equity fund managers can attain the 30% plus gross returns to make it a viable investment. And the problem with finding those funds is the lack of performance data currently in existence, despite the BVCA and EVCA in recent times upping the ante and improving their sets of figures on private equity products. The main issue with consistently selecting good performing funds is that the managers simply haven’t been around long enough in Europe to claim any form of consistency.
“Private equity is an area where the information is very unreliable,” says Stefan Marelid, head of private equity at SEB Investment Management in Stockholm. “The primary problem is that Europe doesn’t have a lot of history, it is very hard to measure private equity if you don’t have any funds that have closed and have a real performance track record. As long as the funds are still open and most of the funds were established during the 1990s and haven’t closed, the statistics on those funds really aren’t mature enough to make a judgement on them.”
As such pension funds have been typically advised to spend anything up to six months to get to know a private equity manager before commiting any assets and placement agents and advisers are becoming more and more instrumental in educating investors in who to opt for and more importantly, who to avoid (see page 52). Placement agent, Helix tracks the top 80 funds in Europe, covering where they are based, their fund history, who their partners are, industry and geographical concentration and investment style. John Barber at Helix in London explains the main points pension funds should be looking at when selecting a manager: “Are they hands on? Do they change management a lot? Do they pursue acquisition programmes and consolidate things or are they hands off, just financial investors who have a board meeting every quarter to see that the company is ticking over? Is there a variety of styles occurring, internally is there a single person who is dominant or do they require uninamity before they take any decisions? Generally these funds are quite small so you are not investing in an institution, you are investing with a set of people.”
Evidently in Europe, the managers who have secured most business have been the large buy-out funds (LBOs), who some say have pretty much cleaned up the market, with an estimated market share of around 80%. “The biggest driver of asset allocation has been the capacity to invest and it has only been the large leveraged buyout funds that have been able to keep doubling their size and invest the capital in a reasonable time frame by buying bigger and bigger businesses. The same thing has happened in venture but the figures are much smaller,” says 3i’s Cook. Deciding what kind of private equity to invest in, be it mezzanine, seed capital, MBOs, LBOS, is driven largely by the risk profile with many funds steering away from early stage venture capital, as in early stage technology investments, on risk grounds. LBO funds have therefore been the traditional favourites of investors for reasons of less risk -typically the individual investments held in an early stage venture fund have a higher risk of losing money than a portfolio of buy out investments. Many early stage private equity managers have actually been moving in to the larger end of the market after establishing a track record on the smaller end, though some in the industry believe that the LBO market is becoming slightly overcrowded with a predicted switch to the middle market in the near future. Cross border investing of course diversifies risk even further and the large buy out end of the market has tended to be more Europe-wide focused than their earlier stage counterparts who have to date remained more country focused.
Whether investors are attracted to the variety of opportunities private equity offers, the ten-year lock in periods have not exactly worked in the funds’ favour in securing capital, despite the fact that pension funds are long term investors. The transparancy issue is, of course, another deterrent in the marketplace. Once the money is invested it is fairly difficult to keep track of it. “In two years time, let’s say you’ve done four transactions and many of these will be small ones. To find out what they have actually done, how much they’ve spent, what the returns they may or may not have made, how they finance these transactions is extremely hard,” says Barber at Helix.
There are of course alternatives which come in the shape of quoted vehicles (see page 56) and the secondary markets. Particularly for first time investors quoted companies and fund of funds such as 3i, Pantheon and Castle give exposure to the asset class and also the much desired liquidity. “The advantage of a quoted fund is that there is a market price and if you want to go into the asset class you can buy into a mature portfolio from day one, whereas if you are pension fund and you decided to allocated 5% to private equity it will probably take five or six years to get to that allocation,” says Thornton at BC Partners. There is a catch of course – these funds tend to be more expensive and the investors lose an element of control over the investments. However fund of fund managers have grown up in the private equity markets precisely because they have allowed pension funds to access a variety of partnerships without employing their limited resources in-house to carry out the necessary due dilligence.
Europe’s secondary markets have seen a growth in interest from pension funds utilising their get-out clause through the likes of Coller Capital who represents amongst other Calpers and British Aerospace as investors into its funds. A pension fund’s investment in a private equity fund has become a commodity in itself with a secondary fund manager such as Coller buying out a pension fund’s commitments, where more often than not the scheme’s investment strategy has changed and private equity no longer figures in its asset allocation. One of Coller Capital’s most recent purchases was the $265m portfolio of Shell Pension Trust in the US, which has been estimated as the largest single sale of a private equity portfolio by a pension fund.
When allocating assets to private equity, it is debatable as to how much a pension fund should invest to make it worth their while. Typical allocations amongst Swedish pension funds for example have hovered around the 0.1-0.3% mark, according to SEB, and taking the diversification argument into consideration, these assets are being spread pretty thinly. UK and Dutch funds have on average invested around 1-2% with some exceptions. Nick Fitzpatrick at Bacon & Woodrow in London believes that to benefit truly from the asset class, funds need to be a bit more adventurous. “If you are investing less than 2%, you’re just playing at it,” he says.
However, the problem with allocating assets lies largely in asset liablity modelling. Conducting an asset liability study to decide what proportion of the portfolios assets should be allocated to private equity may be the first stage in the investment procedure but more often than not has been a preventative factor for pension funds to venture any further. ALM has often been the nail in the private equity coffin.
The asset allocation problem stems from the fact that it is difficult to apply ALM to private equity investments, as there is not enough of a track record to use past performance data and apply it to estimate future returns. Furthermore, a set of investments in a private equity portfolio is very difficult to evaluate and is largely subjective. “It is rather defeated by both property and venture because the statistics are much more sparse,” explains Fitzpatrick. “You get daily statistics on equities, and you get annual statistics on venture.”
Fitzpatrick would prefer funds to put aside this preoccupation with past returns as they are missing out on potentially great yields on their investments. “I think we have to get through that. Everybody tells you that the past is no guide to the future, so why are we doing these ALM studies? We are just looking at the past and building quite ornate models on this stream of data which is not a good guide to the future,but that is the world that we are in.” He adds: “The torturing that we do or our number stream is too high for the quality of the data we are looking at, because so much of the valuation is subjective”
Forthose investors not willing to diversify their assets more the question lies in where exactly they are going to get their added value from. The yields on long bonds are lower than they have been for many years and it is a well known argument of how few active managers can add value to an efficient stock-based portfolio. Fitzpatrick issues a stark warning to these investors: “Stop being driven by the performance measurement and the overfocus on performance measurement that we have been for the last five years.”