Private equity with style
In private equity, the main conventional ways of classifying investments are by geographic location, stage of development (such as venture, mezzanine and buyouts) and industry sector.
However, some industry professionals are claiming that a new type of segmentation is now emerging. According to these experts, the private equity market can now be divided into growth versus value investments.
Champions of this theory include Adveq, the independent private equity fund of funds investment manager.
In its study ‘The Future of the European and Global Private Equity Markets’, Adveq sets out the reasoning behind this new type of classification.
It concludes that the traditional segmentation of the private equity market by sector and geographical region is not the most suitable structure for the future.
“The high volume of private equity activity suggests that the private equity market may well split into two segments,” the analysis goes on.
“Value-oriented investors will target undervalued companies, assets or intellectual property, and try to achieve attractive returns on their invested capital through the generation of recurring cash flows. Value can well be preserved via this approach, but exiting the position will be more challenging. This approach has certain similarities to an equity financing market and may become a full financing business going forward.
“Growth-oriented investors will have to look for aggressive growth strategies with their companies, which should allow them to attract a different pool of potential buyers at the time of exit compared with those at the time of the original deal entry.
“An approach such as this can overcome the discrepancy between the number of deals made and the number of deals sold in private equity. This philosophy is consistent with the original private equity investment approach and requires a full focus on ensuring the strong development of the company. This strategy is only suitable for those investors who are capable of backing market leaders that then can either go public or become an acquisition target for a specific strategic buyer.”
Andre Jaeggi, managing director of Adveq, says: “In most international investment situations, the geographical segmentation will stay. But in addition to that, we see a group of investors believing in a growth story.”
He says that growth is the obvious element which investors look for in beating the public markets. This could come from repositioning a company in the market, or reshaping it to give an additional growth over the underlying economic growth.
“The classic case here is technology,” he says. “That’s where growth will come from.”
At the other end, he says there are high net worth investors looking for sustainable continuous cash flows.
These often invest in companies, which for various reasons may not be in a position to float or refloat on the markets.
“So these investors employ a buy-and-hold strategy,” he says. “In terms of saleability, the end exit will never be the end-target. In this case, investments will tend to be held for a longer period than growth investments.”
Jaeggi says that value investments might be used by charities or foundations, since these types of organisations traditionally rely on a consistent income stream.
“For a pension fund, it depends,” he says. “With a defined contribution fund, you need to achieve additional growth, whereas with a defined benefit fund, you need to achieve certain levels of disbursements in different years.”
Jaeggi says the growth versus value model has been around for some time: “We have had some periods when value investors have been dominant, and where the response to it was an evergreen fund.”
He says the practical use of having such a model is to help investors decide what kind of private equity investment fits best into their asset/liability structure.
“It comes more into play for sophisticated investors who know exactly what they need to achieve to match their liability structure,” he says. “They have to know what their needs are, in terms of when disbursements have to be made from the portfolio. Using this model then means the investor is not betting on geographical cycles, but can assess what types of assets they need to achieve their goals.”
“It is definitely a trend you can see in the market,” says Per Forsberg, director of private equity firm EQT Partners. “And there is clear differentiation in relation to size. For instance, large buyouts such as the Debenhams deal are clearly value investments. They are stable businesses with a very strong cash flow and with good downside protection.”
But, says Forsberg, these companies do not have the greatest growth potential.
“If you’ve invested in the second-biggest company in a particular sector, you can’t buy the top company because of anti-trust legislation. But it is not easy to grow the business otherwise.”
According to Forsberg, many private equity firms are now using either a growth or value route – for instance, Permira, Blackstone and KKR are all primarily value investors.
“But if you look at the smaller funds, you should expect to get much higher returns,” he says. “There is not much interest in a small fund generating the same returns as a big buyout, where there is less risk. So these smaller funds have to differentiate themselves by going more for growth.”
“When we talk to the underlying fund managers, rather than the fund of funds people, we’re trying to work out where they add value,” says Jane Welsh, senior investment consultant and head of the private equity research team at consultants Watson Wyatt. “Is it through smart restructuring, or are they doing something to improve the operational performance of the companies? There are times in the economic cycle when you make more money out of one approach or the other.”
But she disagrees with the idea that investors are looking for a quicker exit from growth than from value investments.
“The time horizon can actually be the other way round,” she says. “That’s what has happened now in Europe – all the businesses spun out of existing entities in the past few years have been shoved on to the stock markets. Costs have been cut - partly through outsourcing functions to eastern Europe - and the companies have been refinanced. So these companies have got more in the way of potential growth than many new businesses.”
She says that in many cases, mature companies throwing off (generating) cash do it out of the public gaze before they go public again.
“That can be quite quick – say two or three years,” she says. “Whereas with growth, people are seeking to invest in more speculative stocks.”
But Sanjay Mistry, head of the European private equity research team at consultants Mercers, is not convinced that Adveq’s definitions of growth and value are the right ones.
“I’d say that growth investments are the more traditional private equity investments, while value investments are the new breed of assets – you could call it infrastructure,” he says. “Investors could use a buy-and-hold strategy for value investments, but should be aware that they are all based on high-risk projects.”
However, he agrees that talking about the classifications does help investors.
“It encourages others to look outside the box and, as a consultant, I’d encourage that sort of behaviour,” he says. “It helps them to look at the marketplace in a different way, and to expand the definition of private equity into the non-traditional private equity field. It might provide a source of greater returns. But you do need to be careful what you’re doing because the value component is a different animal.”