The growth in funds available to private equity houses in Europe has increased dramatically over the...
The growth in funds available to private equity houses in Europe has increased dramatically over the last ten years - especially in the last two or three years. Despite this, Europe still lags markedly behind the USA and it is a notable feature that US-based organisations are now significant investors in UK and European funds.
In 1996 there were very few houses with funds of more than £1bn but such funds are now much more common: the £5bn funds barrier is likely to be broken soon. The reason for these increases can be put down partly to changes in macroeconomics, but it is the success of the sector linked to the size of returns made that has really caught the attention of governments and the European Commission, as well as investors.
In the UK, during the four years to 1998, venture-backed companies increased their staff levels by 24% per year, three times that of FTSE-100 companies and around 70% faster than companies on the FTSE Mid 250. Over the same period, investment by venture capital backed firms rose by 34% compared with a national increase of just 7%.
Over the last few years private equity houses have tended to reduce investment in the £1-5m range and 'deals' tend to be larger, at least partly because of the increased size of funds. According to the Centre for Management Buyout Research, the number of deals involving companies in the £1-5m range dropped by a significant 31% in 1999.
The UK government hopes to change this trend by encouraging investment in start-up entities: it proposes tax breaks for investors in small, high-risk ventures with gross assets of less than £15m and it encourages minority holdings, requiring individual investors to have less than 30% of the entity.
This runs counter to the trends by private equity houses, where deals are getting bigger and percentage holdings in investee companies are increasing now often being over 50%, sometimes over 75%.
With the need to 'add value' and achieve an acceptable internal rate of return (IRR), complex management, financing, structuring and 'change' programmes are required.
A guiding principle for most private equity houses in making any investment is the need for them to see an acceptable exit, whether by IPO, trade sale, break-up or other mechanism. It is critical for the return, usually measured as an IRR, to meet a hurdle rate, both because of investor requirements and to trigger the important 'carried interest' participation. Typically, investors seek an IRR in excess of 25%.
It is the very size of the return that is driving up the size of funds available for private equity investment. There are signs that pension fund investment in alternative investment products is on the increase. However, there is still a long way for it to go before it reaches the levels (up to 5%) often achieved in the US.
There is still distrust of private equity among a number of pension trustees, where the risks are seen to be too high. While currently trustees often allocate less than 0.5% to private equity investments, the effect of low inflation, relatively low interest rates and uncertain stock markets means that they are considering further investment.
There is also greater interest from private banks, family offices of high net-worth individuals and the new internet 'buy-out millionaires', who are prepared to put part of their wealth in a relatively high risk/reward sector. Funds are being put with private equity houses with a good track record.
The effect of the 'feeding frenzy' in internet companies in the last quarter of 1999 has also fuelled interest in private equity. Internet funds launched since the summer of 1999 have been more prevalent and larger than similar sums raised for earlystage technology investments in recent years.
There will be big winners and big losers, depending upon who can get it right in the medium term. Few private equity houses can afford to be out of the sector but the number of opportunities offered has increased exponentially and business plans are often materially less developed and more speculative than for other sectors. However, the ability to 'sell' companies or float on the Alternative Investments Market (AIM) has meant that excellent IRRs have been achieved in the short term.
In the current market, and with the increasing size of private equity funds, it is important to make sure that fund structures are appropriate to investors needs. Following increasing globalisation the needs of investor and limited partners, often from different countries and with different investment criteria and requirements, are increasingly divergent.
The sector is changing - there are huge challenges and opportunities. Who will be the winners, and who the losers will depend at least in part on meeting these requirements in the right way.
Bruce Weatherill is an investment adviser at PriceWaterhouseCoopers
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