Venturing in for the first time
Private equity is quite clearly a high risk asset class, but the corresponding high rewards make it worth considering for an increasing number of pension funds. This kind of investing involves buying into late stage companies – investment in start-ups and early stage companies is known as venture capital.
Part of the rationale behind private equity investing is that investors can add value by influencing management in growing the business. But investors must have at least a 10-year time horizon. They have no rights if things go wrong, and indeed sometimes have to put in more money.
But a successful investment can produce spectacular returns. Rather than buy directly into specific enterprises, however, private equity investments are generally made through funds which invest in a variety of companies, Even greater diversification can be achieved by a fund of funds approach, via a vehicle investing in between 20 and 40 funds. This spreads risk but can still achieve spectacular results – for instance, there are some US fund of funds which have made 30 to 40% a year compound.
“There are two big decisions to be made with private equity investing,” says Kerrin Rosenberg, associate, Hewitt Bacon & Woodrow. “The first is whether it is appropriate, and the second is how to implement it. Consultants such as ourselves do have a role in helping clients understand whether or not it is appropriate. The most important consideration is the client’s ability to enter into a long term environment. The big decision is on entry – after that, there is not much to do. It’s like marriage – you can get out, but you should make the initial commitment on the assumption that you won’t want to change your mind.”
An investor in a private equity fund is referred to as a limited partner. The funds are run by managers – the general partners. These charge an annual management fee – normally between 1.5 and 2.5% – and get a profit share, usually 20% of the profit.
There is a limited period for investment when the fund is launched. After that, the fund has a fixed life, usually of 10 years, with the possibility of two one-year extensions. Investors can get out before the end of the term, but would normally have to sell their share at a significant discount.
Investors commit to investing a certain amount of money over the life of the fund, and this is drawn down (ie, spent) over, say, the first five years. The management fee however is usually charged on the total amount committed, including what has not been drawn down. This means there are negative returns in the first two or three years – the so-called ‘J-curve’.
Finding good private equity funds to invest in requires due diligence on the part of the investor. One big drawback is lack of information flow, as the companies are not quoted, so investors need to dig around for information. Two helpful sources are websites at www.altassets.com and www.privateequityonline.com but it also helps to have a wide network of contacts.
A typical pension fund might put 5% of its portfolio into private equity. When building a portfolio, diversification over a number of private equity funds is essential to spread the risk. For all but the larger pension funds, this can be difficult as many funds have a minimum commitment level in the region of E5m. Thus an institution with assets of E1bn, wishing to allocate, say, 3% would have E30m to commit. At this minimum level of E5m, this would give exposure to only six funds - not very great diversification. Such an institution might therefore consider using fund of funds.
Rosenberg says: “Most investors need a fund of funds, because they need a dozen managers at least. And they have to time that diversification well, by not spending all their money today when other good funds will come along tomorrow.”
He says there are about 2,000 firms which a pension fund might want to invest with.
“If you’re trying to pick 20 or so, you need a fair amount of resources to pick the right ones, so you need to employ several people full-time,” he says. “And to run a team you need to spend at least £500,000 (E733,000) a year. Most funds are not big enough to justify that.”
Rosenberg also considers there is not a long list of credible players among generalist fund of funds managers, covering all sectors. “There are many more specialists who do one region or one speciality such as the US or Europe,” he says.
In contrast with the public equity market, however, Rosenberg says that managers’ track records are important.
“In quoted equities, the best-performing fund last year may be the worst performer this year,” he says. “But in private equity, it is less random. It’s also helpful if the fund of funds manager actually employs people who have themselves done deals.”
Stephan Breban, partner, Watson Wyatt, also suggests a fund of funds approach would be appropriate for most newcomers, but points out its inherent downside.
“The difficulty is that there is an additional charge of 1% pa on the committed amount into underlying funds,” he says. “This in practice means 2% of the investment, since around half the amount committed is going to be waiting for investment at any one time. So people are put off, and think they can hire a consultant to identify the funds instead. That’s OK, as long as someone is given the authority to invest, rather than have to ask the trustees every time a new fund comes along.”
He says that funds of funds are more important for US-based investments.
“In the US market, they can add value because there are far more funds to choose from, so it is hard to identify them,” he says. “The European market is not as diverse, so it is easier to identify the best players.”
Jan Moulijn, member of the investor relations committee at NVP, the Dutch Venture Capital Association in Amsterdam, says that some pension funds new to private equity investing use a core and satellite approach. He says: “They use a fund of funds manager to give them a globally-based diversified core, then invest as limited partners in specific regions or sectors to tilt the portfolio to where they expect the best returns to be.
For instance, a Scandinavian pension fund could invest directly in private equity funds in Scandinavia. One advantage of this is they can use the due diligence of the fund of funds managers in assessing the regional funds, then invest more money into those funds directly.”
But he also says that for other investors, full outsourcing to a fund of funds manager is a better strategy. “This means they need only take an investment decision once every two or three years,” he says. “And they can then fully rely on the selection and portfolio construction capabilities of the fund of funds managers.” The NVP is currently planning to produce an information pack for potential investors, as well as a workshop later this year for new investors to network with each other.
George Anson, managing director of fund of fund managers HarbourVest Partners, agrees. He says: “Many clients start off with, say, 70% of their private equity portfolio in funds of funds, and directly invest the rest themselves. Others simply use funds of funds to gain access to markets they are not familiar with. For instance, we have a large number of US investors who invest in western Europe. They outsource the management of European funds to us, and manage the US market themselves.”
An intermediate step between direct investment in private equity funds (using a consultant) and using a fund of funds is to hire a gatekeeper. This is a firm which can either manage the portfolio on a discretionary basis, or act in an advisory role, with the client making the final decision.
Altius Associates is one company which acts in a gatekeeper capacity.
And its chief investment officer Harry Olieman points out that advisory or discretionary management does have one major advantage over a fund of funds approach.
He says: “The pension fund might have a corporate policy not to invest in a specific area, or to follow an ethical approach to investing. If this is the case, it would not be able to influence the investment decisions within a fund of funds.”