The first question this article may raise is why should I be investing in private equity? The answer is in the performance of the asset class. As figure 1 below demonstrates, for the last 20 years private equity has consistently outperformed the Russell 2000, S&P 500 and S&P 100 indices1.
The second question may be, but why now? The answer to this is because the current economic environment is creating increased pressure on both public and private companies to focus on core businesses, rationalise balance sheets and find alternative sources of cash to finance growth. This situation is creating an increase in the number of opportunities for private equity funds. Most importantly, due to the decline in the public equity markets in Europe since 2000, the entry valuations for private equity are trending downwards. Since the public market valuations are a very important factor in determining entry valuations for the private equity industry, this is likely to have a positive impact on investment returns. The FTSE ALL Share Index and the Dow Jones Euro Stoxx2 have experienced double digit percentage declines similar to those experienced in 1987 and 19983
Overall, the current environment lends itself to making private equity an attractive investment opportunity and asset class. It is critical to note that within private equity as an asset class, as seen in figure 2, there is a much greater range and standard deviation in returns compared with other asset classes and when comparing different quartiles of performance. It is therefore of prime importance to identify those managers which have the potential to outperform their peers within a region or sector and to avoid managers with returns in the bottom half.
There are a number of risks in investing in private equity funds. In our opinion, private equity fund management teams that have some of the following attributes and capabilities are likely to be best positioned to take advantage of these investment opportunities in future years:
o Private equity investment and operating experience. Fund managers should demonstrate that they have been able to buy companies at attractive valuations within the context of the value they have built or realised. Managers having superior operating knowledge of specific industries and who understand an industry’s dynamics and pressures are likely to be able to build companies that have superior market positions (market share), better margins and better growth profiles than their competitors. This is commonly summarised as adding-value to investor companies. In reality, few managers can demonstrate this ability, particularly in down cycles where the wind of the public markets is not behind them. Managers should not rely on financial engineering alone to generate returns. Although leverage and a well-structured investment is an important driver of returns for equity, managers must demonstrate value creation beyond simply the use of leverage and the appropriate capital structure. This is especially true in the current environment where the availability of debt is reduced, public equity markets are down and it is not possible to generate returns on the strength of rising equity markets alone.
o Management talent. Having management talent, with appropriate incentives in place, whilst being unhindered by a large unrealised portfolio or under-performing investments is key to taking advantage of the current investment opportunity (price rationalisation, European integration and legislative changes, etc). In particular, these teams should possess strong sector or industry expertise that will enable them to better understand the value drivers and key issues for a given industry and attract the best industry management teams. The managers should demonstrate that they have and will continue to target those industries that are best positioned for growth over the next three to five years and maximise value creation post-investment.
o Consistency of track record. Consistency of a manager’s performance, especially over a longer period of time, improves the likely return and reduces the volatility associated with it. In recent times many managers have produced “home runs” in their portfolios as a result of market timing and/or “exuberant” public markets, but these individual returns will be hard to replicate and have a distorting effect on the returns of the manager. Managers should demonstrate that they have experienced a low level of attrition (loss of principal/capital) in their track record and that returns are generated across the portfolio and not driven by a small number of big winners. This level of attrition varies depending on the funds investment strategy. Buyout and development/growth capital will have a lower attrition rate than distressed technology and healthcare/bio technology due to the level of risk involved in the varying stages of a company’s development. Conversely, management teams that can show that they have been able to change under-performing portfolio companies to generate positive investment returns as a result of their decisions and abilities, have demonstrated an important investment perspective that is critical in this business.
In conclusion, future years are likely to be good vintage years for private equity in Europe and a valuable source of diversification for institutional investors. In order to make sure that this is the case, it is critical that the selection of private equity fund managers is done in a way that maximises the upside potential that the asset class presents and minimises the downside risks inherent in this business.
o Please note: For investors that are new to this asset class, it is important to remember that private equity/venture capital is a “long term” asset class – capital commitments are usually five years, life of investment vehicles are usually 10 years and performance has to be measured over these parameters.
There is no intention to solicit or recommend any action based on this material.
Rajveer Ranawat is Vice President – European Funds & Direct Investments AIG Global Investment Corp
Sources: Bloomberg, EIU Country Data, Central Interline Agency World Factbook 2001, World Markets Online Country Analysis, Top Performance in Private Equity Conor Kehoe June 2001.
1 US data is used due to the fact that private equity as an asset class has been in existence for longer in the US and availability of data.
2 These indices were used since they are a broad representation for the economies and access to data
3 It is worth pointing out that the late 1980s to the mid 1990s represented periods of reductions in GDP growth rates, similar to the current environment. It is worth keeping in mind that there was negative GDP growth on a YOY basis, in 1991 in the UK and 1993 in Western Europe before recovery and expansion thereafter. Finally, in the current environment the interest rates are lower and so is inflation, when compared to the late 1980 and early 1990s