Super returns for whom?
Private equity is now hitting the headlines from all sides, emphasising its increasing importance in the growth of European economies. According to some estimates, nearly 20% of the UK private sector workforce work for firms owned by private equity managers.
The private equity industry recently had one of its major annual gatherings in Frankfurt at the Super Return conference where the service providers had an opportunity to ponder on the big issues for the coming years.
The low interest rate environment has led to debt financing at very aggressive multiples, driving up prices and leading to the dominance of hedge funds in the mezzanine arena where their lower cost of capital has meant they can outbid the banking sector. The growing encroachment of hedge funds into the private equity arena was a theme that ran through the conference, reflecting a fear by many that the hedge funds can aggressively outbid private equity firms in specific areas such as large buyout transactions.
For private equity managers, the economics of running hedge funds appear far more attractive since the 20% “carry” paid to the managers on capital gains is paid out annually for hedge funds on all gains, both realised and unrealised, and without any hurdle rate. Private equity firms, however, have to wait until they can actually realise the cash through selling their investments and achieve a hurdle rate of typically 8% before they can benefit.
Whether hedge funds have the skills to add value over the long term was a debateable point, although, as was pointed out, hedge fund managers can buy-in skills given their superior compensation packages and there is already some evidence that they are able to poach high calibre individuals from the private equity sector.
For investors, key issues relate to the absolute and relative pricing of private equity. Will debt markets remain healthy enough to be able to continue to finance transactions at the current multiples? With a number of major firms undertaking aggressive fund raising in the buyout sector, is there too much money there chasing too few transactions?
Venture by contrast continues to languish, despite its critical role in
the development of European economies, which prompts the
question: Does venture’s recent unpopularity present an investment opportunity?
Fund of fund players tend to be very wary of venture investment, with justification. As Ernie Richardson of MTI noted: “European venture attracted a poor reputation for some justifiable reasons. Whilst some individual funds have performed well, as an industry it has not had a stunning performance.”
The contrast with the US is also striking, David Cooksey of Advent pointed out that in Europe, the deal size is much smaller, with between a fifth and a third of the deal size seen in the US going into a European venture deal.
Richardson also noted that in the US there are top tier “white holes” –
venture capital firms which are so well regarded, and which have such good connections that they attract great companies and the companies they invest in get a tremendous boost from this involvement.
Firms such as MTI are attempting to improve the quality of exits for investee companies through building up networks in specific sectors to tap into opportunities for business activity and exits. As Richardson puts it, “the challenge for a venture capitalist is feedback from the outside world: What is happening in Japan, in Germany and elsewhere?”
What is clear is that institutional involvement in venture will be very limited if the only route is through fund of funds, which have limited appetite. UK pension schemes, for example, look to their investment consultants for advice on investment in private equity. Consultants cannot justify hiring staff to undertake the detailed due diligence on individual private equity firms which would enable them to recommend a portfolio of suitable investments. Invariably, therefore, they suggest a fund of funds approach.
Does this mean that for the sake of 10 or 20 staff with specific private equity responsibilities in the handful of firms that dominate investment consulting, the European venture capital industry is deprived of billions of investment from institutional pension schemes? Some private equity players certainly think so, but then a few years of stunning performance can make all the difference.