Removing the obstacles
In 1997, some institutional clients gave a clear task to Partners Group, a Swiss- based private equity asset manager. The task was to design a product that would enable them to invest in the attractive asset class of private equity and at the same time take away the disadvantages that are usually bound up with such investments.
In general, access to this asset class is hindered by lack of transparency, high minimum investment requirements, difficult entry to sought-after partnerships, lack of liquidity and long lock-up periods. In addition, in many continental European countries, important institutional asset managers such as pension funds are prevented by national regulations from investing in such risk bearing equity asset classes.
Less than two years later Princess Private Equity Holding Limited, a Guernsey-registered private equity investment company, was formed as a joint venture by Swiss Re and Partners Group. The transaction structure on which Princess is based was recognised by The World-wide Reinsurance Review as the most “different and well thought-out” concept in its category and was voted “innovative financial product of the year 1999”.
The judges of the award committee described Princess as a tremendous step forward in broadening the private equity investor base, as the structure would for the first time make it possible for restricted institutional investors, pension funds, other institutions and private individuals – mainly in Switzerland and Germany – to invest in this special asset class. A new term – Insuritisation – was coined for the Princess concept to describe the insurance of an alternative asset class and the opening up of a new field where the insurance industry takes on risk from the financial markets.
In December 1999, Princess closed its fund-raising process at the amount of $700m, provided by the issuance of 700,000 zero coupon convertible bonds each with a par value of $1,000. Approximately 80% of the bonds were placed with long-term-oriented institutional investors, such as insurance companies and pension funds, mainly in Germany and Switzerland. Approximately 20% were purchased by private investors. Through its Frankfurt and Luxembourg stock exchange listed bond, Princess removes the investment obstacles described above and provides institutional and private investors with a Standard & Poor’s AAA-rated security within the attractive asset class of venture capital/private equity, while the par value of their investment is protected at maturity under insurance arrangements reinsured by Swiss Re. Furthermore, most regulatory bodies allow institutions to account for their investment in Princess as a bond position, instead of equity, and the German authorities even rated the Princess bonds as a risk-free asset allocation suitable for investment by Germany’s heavily restricted insurance companies (Deckungsstockfähigkeit).
During the process of developing Princess, the joint venture partners Swiss Re and Partners Group recognised that private equity is not only a most attractive but also a very complex asset class. It must be approached with a specific and sophisticated methodology to ascertain and manage this type of risk exposure. Therefore considerable efforts were made to develop a private equity risk/return model created on the basis of historical world-wide private equity data, some of which date back to 1969. The model assists Princess in quantifying and optimising risk and return on private equity investment decisions by making the appropriate and most efficient portfolio allocation.
Compared to public equity, diversification is not only achieved by geographic regions, but also through the array of private equity investment styles – such as, for example, early and later stage venture, small, mid-size and large buyout, or special situations. A further diversification and optimisation of the Princess investment portfolio consists of combining different vintage years (defined by the year in which the partnerships were launched) as well as the fund size. According to the model, the expected annual return for the Princess investor could be approximately 12–15%.
The development of Princess’s private equity risk/return model also created another powerful tool to maximise returns on investors’ paid-in capital. The analysis of statistical data from Venture Economics found that investments in private equity have a peak level of 65%, leaving the remainder of the investors’ committed capital invested in short-term instruments. This is due to the fact that the amount committed is not entirely drawn down by the partnerships and distributions to investors already start during the investment period. Further, an institutional asset manager must reserve the full amount of his commitments, so that his strategic asset allocation is never truly fully invested in private equity. Moreover, the resulting opportunity cost dilutes the overall performance of the investor’s private equity allocation by approximately one third.
Swiss Re and Partners Group’s proprietary over-commitment model, which is part of Princess’ investment strategy, provides a solution to this problem by using cash returns from the portfolio to meet future capital calls. By this means a full investment level can be achieved within a shorter period and – after the initial build-up phase – be sustained over time.
As of the end of December 2000, Princess proved to be well on track in its planning. More than 60% of the bonds’ par value was already invested into (or drawn down by) the 94 partnerships worldwide in the Princess portfolio, to which a total amount of more than $1bn had so far been committed. Divided by geographic regions (60% US, 40% Europe and 10% rest of the world), the investment criteria have provided a portfolio that is well balanced by investment stages and vintage years. Several important acquisitions of already existing secondary private equity portfolios contributed to that impressive result within this – for private equity terms – relatively short period. Princess’s net asset value increased more than 4% during its first full fiscal year and on December 31, 2000 stood at $721m.
Swiss Re and Partners Group continue to believe that private equity will gain further importance, especially in continental Europe and that large institutional investors will increase their allocation to private equity. As the Princess bonds provide high expected returns related to marginal risk and low correlation to public markets, it can be expected that they will continue to attract even conservative portfolio managers.
Stefan Schaechterle is general manager of Princess Private Equity Holding Limited