There is a common perception that private equity is risky but by diversifying holdings between buyout funds and the venture capital sector it is possible to minimise any risk
Private equity has for many years been used by US investors, particularly pension and endowment funds, as an asset class offering significant diversification benefits from the public markets in addition to the potential for enhanced investment returns.
In contrast, the European private equity market has been slow to develop until relatively recently. As an indication of this, a Goldman Sachs and Frank Russell report on Alternative Investments in 2001 found that those US institutions with private equity investments have approximately 7.5% of total assets allocated to private equity while in Europe the comparable figure is just 3.6%.
Private equity is the term used to cover equity type investments in companies that do not have a stock exchange listing. By definition, therefore, investors have no marketplace where their investments can be traded.
So they are committing themselves for a significant period of time unless they can find a buyer and negotiate a price for the transaction.
The lack of marketplace also means that current valuations may not be readily available when the investor wishes to perform an investment valuation or analyse performance.
Most private equity investment is channelled through various investment vehicles, such as private equity funds or funds of funds that offer the investor a diversified portfolio of direct and/or fund investments.
Private equity funds tend to have a fixed life, typically 10 years. Investors are generally asked to subscribe their capital commitment in a series of phased payments stretching over several years as the managers find suitable investments. Throughout the fund's life, the manager will be aiming to create value in the investments by growing revenue and increasing profits and then selling the investments either by listing on a stock market or selling the business to another company.
The proceeds of sale of those investments are then returned to investors. Investments made early in the life of the fund are often sold before all the capital is subscribed. This process results in lumpy investment flows for the investor, unlike other types of fund.
This structure contributes to a typical 'j-curve' valuation pattern over a fund's life. At the start of the fund's life, the management costs are spread over a low capital base, resulting in disproportionately high percentage costs during this phase. In addition, the investments are normally valued at cost for at least the first couple of years following the date of the investment being made.
As the fund matures, the manager expects to increase the valuation of its investments for a variety of reasons. One cause of higher valuations could be readily apparent increases in profitability or the cash flow generation capability of the company.
Another may be further transactions in the stock as further capital is raised or existing shares are transacted or as the pricing of an exit strategy becomes more visible. This can provide a significant lift to the valuation later in a fund's life.
To illustrate these trends in reality, the chart above right shows the average return profile over time for six European private equity funds launched in 1992 with an aggregated committed capital of e521m. In comparing the performance of funds it is important to bear in mind this pattern of returns.
Performance data is a key issue in this market. Because the industry is relatively new in Europe, there is no returns data going back more than about 20 years to provide a reference for investors.
The European Private Equity & Venture Capital Association (EVCA) has been collecting fund data since 1980, but it covers only those funds for which managers have volunteered to supply information.
Over time, the number of funds has increased so it is becoming more representative. Even in the US market, which is far more established, performance data does not cover the whole market and is therefore open to bias.
It is often thought that private equity only involves investing in start up companies but this is one of the myths. Private equity can take many forms, ranging from a variety of venture capital forms through to buyout situations, involving a change in ownership of established businesses, and special situations such as project finance or distressed debt which takes on the characteristics of an equity type investment. In recent years, the buyout sector has been providing more opportunities and in the chart below left we show the distribution by type of private equity investments made in Europe in 2001.
Last year, for example, companies such as Halfords and KwikFit (both purchased by CVC from Boots and Ford respectively), National Car Parks purchased by CinVen from Cendant and Calvin Klein purchased by Apax were significant buyouts.
The underlying investments in a private equity fund are in company equity or equity related investments so the macro influences, such as economic growth and inflation, that impact on the business performance of listed companies will also affect the business performance and valuations of private companies. The capital structure of the investee firms may be different and the spread of their business interests may be narrower than is typical in the listed sector. However these macro influences should ensure that long term trends in investment returns for private equity are similar to those for the listed sector.
Companies backed by private equity investors do however offer a higher earnings growth profile and return on capital than the listed sector. This is because either the business may be exposed to faster growing sectors of the economy, or subject to more stringent management of costs, cashflows and working capital. In addition, the capital of the private equity investors may be structured to include more gearing thereby enhancing the potential returns available to private equity investors.
In private equity deals the companies are not judged by quarterly earnings numbers and so can invest for the long-term. When private equity firms buy a company, the focus is on value creation ' through increasing sales and reducing expenses for example. Often these companies will look at 'buy and build' strategies where they purchase a series of small companies in the same sector and create a large business which attracts the attention of the major player in the market or is able to be listed itself.
Despite the caveats set out above, it is instructive to review reported performance results.
The EVCA preliminary report for 2002 on the industry includes data on 765 funds with capital commitments amounting to e129bn, compared to only e21bn in 1996. This increase illustrates the rapid growth in European sector produced higher returns than the buyout sector (17.3% compared to 13.6%) the buyout funds were further ahead of their comparator indices (by 7.2% compared to 5.8%).
The significance of this is that it would be wrong to allocate money to the venture capital sector rather than to the buyout sector in the anticipation of earning higher returns. In fact, the opposite is true. The apparent outperformance was due only to the different incidence of the cashflows into and out of the venture capital sector compared to the buyout sector.
The balanced venture capital results shown in the table include the period of inflation in technology stocks in the late 1990s.
This would have also inflated the venture capital results relative to the other sectors of the private equity market. The other sectors had lower returns than the overall return and were below their MSCI equity comparator.
Although, the analysis is couched with caveats, the evidence is reasonably strong that private equity offers the prospects of higher returns than are likely in listed equities.
Perhaps the most common myth about private equity is that it is very risky. Part of this belief stems from the earlier concentration of the industry in venture capital which is undoubtedly at the more risky end of the spectrum.
Also, as with other types of investment, risk increases with concentration and there is no doubt that individual venture capital investments have a high failure rate. Fund investments offer greater protection through diversification than individual direct deals. But there are also some spectacular winners, so a well diversified portfolio of various private equity funds can further reduce the risk of loss.
The risk of loss can also be mitigated by diversifying among the various types of private equity. Buyout funds for example have a low correlation with venture capital. This is hardly surprising as buyouts are generally strong, established businesses. Data from Venture Economics in their 2000 edition annual report, for example, shows a correlation of only 0.05 between the two types in the US, calculated on annual returns over the previous 17 years.
Returning to the European scene, the greater riskiness of venture capital compared to buyouts can be seen in the table where the one year returns from the EVCA database for the last three years are shown.
Perhaps one of the main reasons why UK institutions invest less in private equity than their Continental European counterparts is due to regulatory constraints. For example, solvency requirements in recent years have discouraged UK pension funds from investing in assets that are not included in the benchmark index used to calculate the yield for valuing liabilities. Private equity has not been part of this benchmark.
The Myners report recommended that this requirement be replaced with more suitable solvency tests and the Government is currently considering these but in the meantime, changes in accountancy standards are providing further discouragement to investing in equities of any kind.
The skills required to invest successfully in private equity are different from those required for investing in the listed market. The whole process is much more labour intensive and requires multiple skills such as business strategy and planning, accounting, tax and legal. As we have referred to several times, there is a lack of good quality historic data. In addition, direct private equity investment may well require negotiating skills and there will certainly be a significant volume of legal work.
There could also be an element of working with investee companies on strategic development and on finding ways of achieving liquidity. For many, outsourcing is the only viable solution and there are a number of ways to do this. The approach that has gained most momentum in recent years is to invest via a fund of funds. These managers of managers account for the fastest growing source of private equity funds in the last five years. Fund of funds are usually structured along similar lines to private equity funds compared to the European average of 3.6% and the US average of 7.5% highlighted earlier, this suggested allocation is significantly higher.
There are, however, a number of reasons why such an allocation is unrealistic, not least the fact that the private equity market at present could not accommodate it except for comparatively small portfolios. For example, the data may not be representative and different results could be obtained from a different sample. Nonetheless, the risk and return characteristics suggest that a higher allocation than is currently the norm in Europe would be beneficial to overall performance.
Of course, a private equity fund will eventually generate liquidity as the managers return capital and profits to the investors. In this respect, funds are generally self-liquidating. But, normally we define liquidity in terms of the ability to convert the investment into cash at a time of the investor's choosing.
In this respect, there is a widely held belief that private equity investments are illiquid assets. Their nature suggests that this belief is justified but it is perhaps worth comparing their illiquidity with other assets that funds have a higher exposure to.
The most obvious comparison to draw is with property. Although the property market is very large with significant numbers of buyers and sellers, it still remains an illiquid asset class. The negotiation of a property transaction takes between three and six months to complete which, in conjunction with the sizeable transaction costs (stamp duty, legal fees etc), makes for a lack of liquidity, at least in the medium term. In addition, each investment is unique and market information on pricing is not readily disseminated. While investments in private equity limited partnerships are illiquid, there is a growing secondary market.
Investors can have a need, because of changing circumstances, to reduce or even eliminate their allocation to private equity. As they are keen to sell, their interests have usually been offered at considerable discounts to NAV in order to attract a buyer. Recently, these discounts have attracted more buyers to the secondary market and, in time, these discounts will probably erode. This in turn will make the secondary market a viable option for those investors seeking liquidity.
The biggest criticism of these vehicles is this double fee structure, but for most institutions the additional fees would be more than outweighed by the costs of developing the same level of expertise in-house, especially given the average size of private equity allocations. Only when these allocations become significant does it pay for the expertise to be brought in-house. The private equity market is still relatively new in Europe. There is no long term database of performance characteristics as there is for the listed investments and, partly for this reason, there are certain beliefs held by investors that can be challenged.
In particular, private equity is widely held to be much more risky than investing in listed equities. But shareholders of companies such as Marconi, Ahold and Enron will tell you about the high risks in listed markets. The analysis we have done show that these beliefs are really myths and we hope that this article helps to dispel them.
Private equity should have a place in many portfolios but investors need to be sure that when they are considering an investment (be it in an investment trust or a fund of funds) that their preferred manager has the experience to make informed, balanced and reasoned decisions based on process, due diligence and professional judgement.
European private equity market are relatively underdeveloped.
Private equity offers greater return potential than listed equities.
Risk can be controlled by diversifying investments.
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