Looking for better times ahead
While analysts seem to be fairly optimistic about global public equity markets, the same assumptions cannot be automatically made for the private equity sector. This sector is as dependent on the circumstances of individual companies as it is on general market sentiment, so it does not necessarily follow that either returns or investor participation will closely reflect the trend of the publicly quoted sector.
IPE asked managers of some of the biggest European pension funds how they viewed the prospects for private equity investing in the coming year.
Harald Wouters is corporate communications manager, MN Services, which runs the private equity portfolio of the Pension Fund for Metalworking and Mechanical Engineering, the third largest pension fund in the Netherlands. The fund invests in private equity as a limited partner.
Wouters says: “If the equity market recovery holds and the IPO window re-opens, it should be a good year for exits, and a decent year for fundraising. But rising prices will hurt deal-making in 2004.”
Wouters says the fund expected to invest roughly E200m in private equity during 2004.
Stephen Lowe is head of asset strategy, Rail Pen Investments, advisers to the trustees of the UK railway workers’ pension fund.
The fund includes a private equity portfolio of around £500m (E733m), out of total assets of £14bn. That section of the fund is run by nine external managers.
The fund’s private equity portfolio is largely made up of direct and direct fund investments. There are, however, some fund of fund holdings, and these are increasing as a percentage of the private equity portfolio.
Lowe says: “Last year, private equity investments underperformed global equities. Our private equity portfolio was still reflecting deteriorating values in the summer. This year, however, we are looking for a reversal with some fairly early realisations, and exits with an uplift over book value.”
In terms of new investments, Lowe says that prospects for the current year appear to be much better than 2003.
“We expect to return to a normal level of activity,” he says. “We have been committing steadily, but the drawdown was quite slow until nine months ago, since when it has picked up pace.”
But he warned that quantity does not necessarily imply quality. “There’s definitely more activity, but managers always say there are good deals around,” he says. “There was loads of activity in 1999 too, but there were some awful deals on offer, as part of the technology boom.”
Giant Swiss pension fund ABB Pensionskasse is run by external managers Avadis Vorsorge. Avadis Vorsorge runs four closed-ended private equity funds and also delegates some management globally, using a multi-manager approach.
Daniel Dubach, chief investment officer, Avadis Vorsorge, says: “We visited Silicon Valley last October, and got the impression that it’s a very exciting time to be investing in private equity. The market has now bottomed out, and we can see the first signs of improvement.”
Last year, the fund’s managers saw different returns in different sectors of the pension portfolio.
“With the oldest private equity programme, there has been two years of declining value in the portfolio, during which some investments were written off or written down,” says Dubach. “However, we saw a bottoming out last year, and there now seems to be better value.”
It did not help, however, that 60% of the private equity portfolio is invested in the US, compared with 30-40% in Europe and a small amount in Asia.
“Including the effect of the declining dollar, returns last year were negative,” says Dubach. “But returns for the oldest programme were only slightly negative – the younger the programme, the more the dollar’s decline is weighted in the portfolio.”
ABB has a total 4% of its portfolio invested in ‘alternative’ assets, made up of 3% in hedge funds and only 1% in private equity.
“It is unlikely we will be growing the 1% because of liquidity constraints, as there is a relatively high number of pensioners in the fund,” says Dubach. “However, we will be putting more into private equity this coming year than last year, during which we invested practically nothing, because of the turmoil in the markets, and problems with company balance sheets.”
In contrast, Rail Pen has 3% of its portfolio in private equity, but this is well below its target of 6% for the less mature sectors of the fund.
“We intend to reach our target with the commitments we are making,” says Lowe. “For the mature sectors, the allocation is from nil up to 3%, but these sectors form only a small part of the fund. This coming year, we will be committing around £100m to the private equity sector, which is much the same as last year and the year before. But of course, at what date precisely we reach our target depends on how the assets perform.”
He says: “I believe the adage ‘Don’t invest too much when people are optimistic, and don’t invest too little when people are depressed’ still holds true.”
The European fund with the biggest percentage allocation in private equity is PGGM, the pension fund for Dutch health workers. All of the fund’s private equity portfolio is managed externally by NIB Capital, which it jointly owns with ABP.
About 5% of the pension fund’s portfolio (E53bn as at end-2003) is held in private equity. This is expected to remain between 5% and 7% from the asset-liability-mix) in the near future.
Last year, the fund made a return of 3.3% from private equity. This year, the fund managers still expect to achieve a positive return, but they do not have a specific forecast.
“PGGM invests in private equity because the forecast returns on this category of investments over a longer period are on average higher than those of other investment categories,” says the fund’s spokesman Alfred Kool. “The returns are largely dependent on economic developments. As long term investors, we are not focused on one specific year.”
In terms of the stage of development of the companies bought into, buy-outs seem to be more popular than early-stage investing. Two of the funds – ABB and Rail Pen – both say that 60% of their private equity portfolio was in buyouts, with 40% in venture capital. RailPen includes a smattering of special situations and mezzanine finance within the early stage portion.
The private equity portions of the big European funds do not generally have an annual target return – performance is measured more on a long-term basis. However, target returns are generally linked to an appropriate benchmark, after deducting costs.
For two funds, 3% is the crucial figure. MN Services aims to outperform the public equity market by at least this amount, while ABB expects to achieve 3% per year above the Russell 3000 Index.
Rail Pen’s target is more ambitious – some 5% over public equity (the fund has its own global equity benchmark).
Says Lowe: “Over the long term, private equity returns have beaten public equities by this percentage.”