Introduction and Background to the Asset Class
Private equity has arrived as a major component of the alternative investment universe and is now broadly accepted as an established asset class within many institutional portfolios. Many investors still with little or no existing allocation to private equity are now considering establishing or significantly expanding their private equity programs.
Private equity is often categorized an alternative investment, comprising a variety of investment techniques, strategies and asset classes that are complimentary to the stock and bond portfolios traditionally used by investors.This chartshows the main components of the alternative investment space at a broad level.
Private equity investing may broadly be defined as investing in securities through a negotiated process. The majority of private equity investments are in unquoted companies. Private equity investment is typically a transformational, value-added, active investment strategy. It calls for a specialized skill set which is a key due diligence area for investors assessment of a manager. The processes of buyout and venture investing call for different application of these skills as they focus on different stages of the life cycle of a company.
Private equity investing is often divided into the categories described below. Each has its own subcategories and dynamics and whilst this is simplistic, it provides a useful basis for portfolio construction. In this article, private equity is the universe of all venture and buyout investing, whether such investments are made through funds, funds of funds or secondary investments.
Venture capital is investing in companies that have undeveloped or developing products or revenue.
Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase.
Financing for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their products commercially and are not yet generating a profit.
Financing for growth and expansion of a company which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. This stage includes bridge financing and rescue or turnaround investments.
Purchase of shares from another investor or to reduce gearing via the refinancing of debt.
A buyout fund typically targets the acquisition of a significant portion or majority control of businesses which normally entails a change of ownership. Buyout funds usually invest in more mature companies with established business plans to finance expansions, consolidations, turnarounds and sales, or spinouts of divisions or subsidiaries. Financing expansion through multiple acquisitions is often referred to as a buy and build strategy. Investment styles can vary widely, ranging from growth to value and early to late stage. Furthermore, buyout funds may take either an active or a passive management role.
Special situation investing ranges more broadly, including distressed debt, equity-linked debt, project finance, one-time opportunities resulting from changing industry trends or government regulations, and leasing. This category includes investment in subordinated debt, sometimes referred to as mezzanine debt financing, where the debt-holder seeks equity appreciation via such conversion features as rights, warrants or options.
What are the main sources of private equity finance?
The spectrum of investors in private equity has expanded rapidly to include different types of investors with significant long-term commitments to the asset class. The majority of commitments to private equity funds based in respective geographical regions have come from institutions within the same region. This is evolving as investors seek a higher level of geographical diversification in their private equity portfolios.
The fundamental reason for investing in private equity is to improve the risk and reward characteristics of an investment portfolio. Investing in private equity offers the investor the opportunity to generate higher absolute returns whilst improving portfolio diversification.
The long-term returns of private equity represent a premium to the performance of public equities. This has been the case in the US for over 20 years and also in Europe, following an increase in the number of private equity funds, for over 10 years. For many institutions, such a premium over more conventional asset classes justifies the different risk profile of the asset class.
True stock picking in a low inflation, low growth environment
A low inflation environment creates a focus on growth stocks as a means of out-performance. One of the core skills of the successful private equity manager is to pick companies with growth potential and actively to create the conditions for growth in those companies. Since private equity funds own large, often controlling, stakes in companies, few, if any, other private equity managers will have access to the same companies. Private equity managers are therefore true stock pickers. This contrasts to mutual funds, which will often hold largely the same underlying investments as their peer group, with variations in weightings being fine-tuned to a few basis points.
Excessive volatility and poor investment performance experienced by quoted equity portfolios, many of which have index-tracking strategies or are benchmarked to an index (closet trackers), have led to a swing in favor of strategies that seek absolute returns.
Demographic trends have compounded the desirability of such a change. The need to provide for an ageing population has obliged many institutions to adopt a more absolute return oriented investment approach in order to meet future liabilities. Private equity managers do seek absolute returns and their traditional incentivisation structure, the carried interest, is highly geared towards achieving net cash returns to investors.
Portfolio diversification improves risk and volatility characteristics
Within a balanced portfolio, the introduction of private equity can improve diversification. Although lower correlation of returns between private equity and public market classes is widely debated and needs further investigation, the numbers do indicate a lower correlation.
The private equity industry has brought corporate governance to smaller companies and provides an attractive manner of gaining exposure to a growth sector that went out of favor with market investors in the mid 1990s for reasons of liquidity.
A much greater depth of information on proposed company investments is available to private equity managers. This helps managers more accurately assess the viability of a companys proposed business plan and to project the post-investment strategy to be pursued and expected future performance. This greater level of disclosure contributes significantly to reducing risk in private equity investment. Equivalent information in the public markets would be considered inside information. By definition, investors in public markets will know less about the companies in which they invest.
The wider emergence in Europe of entrepreneurs as an important cog in the economy has been facilitated by a period of larger company rationalization. This has reflected similar developments in the US that, for example, fostered rapid growth in technological innovation and substantial knock-on benefits for the whole economy through the 1990s. Entrepreneurs have also been at the heart of developments in Europe, creating value in both traditional and hi-tech industries. The private equity asset class offers the ability to gain investment exposure to the most entrepreneurial sectors of the economy.
Influence over management and flexibility of implementation
Private equity managers generally seek active participation in a companys strategic direction, from the development of a business plan to selection of senior executives, introduction of potential customers, M&A strategy and identification of eventual acquirers of the business. Furthermore, implementation of the desired strategy can normally be effected much more efficiently in the absence of public market scrutiny and regulation. This flexibility represents another feature whereby risk can be reduced in private equity investment.
Buyout managers in particular are able to make efficient use of leverage. They aim to organize each portfolio companys funding in the most efficient way, making full use of different borrowing options from senior secured debt to mezzanine capital and high yield debt. By organizing the companys funding requirements efficiently, the equity returns are potentially enhanced. In addition, because the leverage is organized at the company level and not the fund level, there is a ring-fencing benefit: if one portfolio company fails to repay its borrowing, the rest of the portfolio is not contaminated as a result. Thus the investor has the effective benefit of a leveraged portfolio with less downside risk.
However, there are features that investors might not find attractive and which must be understood.
In general, holding periods between investment and realization can be expected to average three or more years (although this may be shorter when IPO markets are especially healthy). Because the underlying portfolio assets are less liquid, the structure of private equity funds is normally a closed-end structure, meaning that the investor has very limited or no ability to withdraw its investment during the funds life. Although the investor may receive cash distributions during the funds life, the timing of these is normally uncertain. Liquidity risk is one of the principal risk characteristics of the asset class. Private equity should therefore be viewed as a longer-term investment strategy.
As a result of the active investment style typical of the industry and the confidentiality of much of the investment information involved, the task of assessing the relative merits of different private equity fund managers is correspondingly more complex than that of benchmarking quoted fund managers. This makes investment in private equity funds a much more resource-intensive activity than quoted market investment. Likewise, postinvestment monitoring of funds performance is also more resource-intensive. Resource is a key issue in the development of a private equity program that is suitable for the investor.
When committing to a private equity fund, the commitment is typically to provide cash to the fund on notice from the general partner. Whilst launch documentation will outline the investment strategy and restrictions, investors give a very wide degree of discretion to the manager to select the companies that the investors will have a share in. Unlike some real estate partnerships, there is usually no ability at the launch of a private equity fund to preview portfolio assets before committing, because they have not yet been identified. Also, there is generally no ability to be excused from a particular portfolio investment after the fund is established.
Portfolio construction will reflect the principal objectives of investing in private equity, including targeting higher long-term returns and portfolio diversification through reduced correlation to public equity markets. Issues of correlation will apply not only in connection with other assets, but also amongst the assets in the private equity portfolio itself.
Decision 1 – The size of the private equity allocation
Investors in private equity should be able to accept the illiquid character of their investment, hence the extent to which liquidity may be required is often a factor in the size of allocation. For this reason, it is often the case in the US that the investors who make the largest proportional allocations to private equity from their overall portfolios are those who are able to invest for the long term with no specific liabilities anticipated. These would include endowments, charities and foundations. Pension funds also are often large investors in the asset class. Based on the requirement to increase targeted returns and/or reduce volatility, the investor will determine the proportion of its overall portfolio that it believes is appropriate to allocate to private equity.
Decision 2 – Number of private equity funds to commit to
It is a challenge for investors to avoid concentration of risk within their private equity portfolio and to control portfolio volatility. It is appropriate to aim for some diversification. The chart below indicates that a level of diversification can be achieved by holding at least 6 different funds.
Decision 3 – Ways of achieving diversification
There is negative correlation between returns from different stages of private equity. Diversification can therefore reduce risk within a private equity portfolio and this should be an important consideration.
Geographical diversification can be secured in Europe through the use of country-specific, regional and pan-European funds. Non-European exposure is also widely available, in particular through US funds, but also for example through Global, Israeli, Latin American and Asian funds.
Selecting a variety of managers will reduce manager specific risk.
Timing has an impact on the performance of funds, as opportunities for investment and exit will be impacted by external economic circumstances. For this reason it has become a normal practice to compare the performance of funds against others of the same vintage. There may be marked differences in performance from one vintage year to another. In order to ensure participation in the better years, it is generally perceived to be wiser to invest consistently through vintage years, as opposed to timing the market by trying to predict which vintage years will produce better performance.
In venture investing, most of the focus tends to be on technology based industries. These can be subdivided, for example into healthcare / life sciences, information technology and communications. Buyout funds tend to focus on technology to a lesser extent, providing exposure to such sectors as financial institutions, retail and consumer, transport, engineering and chemicals. Some have a specific sector focus.
Given the typical minimum investment size of private equity funds, establishing a diversified portfolio will require certain minimum levels of capital commitment. It will also take time to put into effect, bearing in mind vintage year diversification and the over-riding objective to identify the best managers in a given area.
Decision 5 – How to plan for the volatility of cash flows – the J-curve
An investor is typically required to fund only a small percentage of its total capital commitment at the outset. This initial funding may be followed by subsequent drawdowns (the timing and size of which are generally made known to the investor two or three weeks in advance) as needed to make new investments. Just-in-time drawdowns are used to minimize the amount of time that a fund holds uninvested cash, which is a drag on fund performance when measured as an internal rate of return (IRR). Investors need to maintain sufficient liquid assets to meet drawdown obligations whenever called. Penalty charges can be incurred for late payment or, in extreme cases, forfeiture of an investors interest in the fund. In most funds early years, investors can expect low or negative returns, partly due to the small amount of capital actually invested at the outset combined with the customary establishment costs, management fees and running expenses.
As portfolio companies mature and exits occur, the fund will begin to distribute proceeds. This will take a few years from the date of first investment and the timing and amounts will be volatile.
When drawdowns and distributions are combined to show the net cash flows to investors, this normally results in a J-curve, illustrated in the chart below. As distributions normally commence before the whole commitment has been drawn, it is unusual for an investor ever to have the full amount of its commitment actually managed by the manager. In the illustration below, net drawn commitments peak at around 80%.
The principal means of private equity investment are:
While it is sometimes the ultimate objective of investors to make direct investments into companies, compared with investing through funds it requires more capital, a different skill set, more resource and different evaluation techniques. Whilst this can be mitigated by co-investing with a fund and the rewards can be high, there is higher risk and the potential for complete loss of invested capital. This strategy is recommended only to experienced private equity investors. For most investors the use of private equity funds would be preferred.
In-house private equity fund investment program
Investors in a fund generally expect to gain broader exposure through a portfolio built during the commitment period by investment professionals who specialise in discovering, analysing, investing, managing and exiting from private company investments. Being diversified amongst a number of different investments helps ensure that the risk of total loss of capital in the fund is relatively low compared to investing directly in unquoted companies. Compared to quoted equity funds, private equity funds often invest in relatively concentrated portfolios, for example there might be 1015 companies in a typical buyout portfolio or 2040 companies in a venture capital portfolio.
A fund of funds is a pooled fund vehicle whose manager evaluates, selects and allocates capital amongst a number of private equity funds. Because many funds of funds have existing relationships with leading fund managers, and because commitments are made on behalf of a pool of underlying investors, this can be an effective way for some investors to gain access to funds with a higher minimum commitment or to heavily subscribed funds. Many funds of funds are blind pools, meaning that exposure to particular underlying funds is not guaranteed. Rather the investor is relying on the record of the manager to identify and secure access to suitable funds. Some funds of funds, however, disclose a preselected list of investments. Investors in funds of funds need to balance the extra layer of management fees and expenses involved against the cost of the extra resource that the investor would need itself to select and manage a portfolio.
Consultants will offer similar expertise to fund of fund managers, but may offer a choice of discretionary or advisory services. The latter will facilitate construction of a tailor-made portfolio, as opposed to committing to a blind pool alongside other investors. Consultants may also offer segregated rather than pooled accounts. Consultancy services are also offered by some fund of funds managers.
An example of a simplified fund structure is provided in the graphic below.
Often it is necessary to create two or more vehicles, with different structures or domiciles, to permit investors in different countries to co-invest in a common portfolio. Two of the principal considerations in any fund structure are:
– the structure should not prejudice the investors tax position; and
– investors should have the benefit of limited liability.
In relation to tax, it is important that there should be no additional layer of tax at the level of the fund, nor should investors be rendered liable to tax in another country as a result of the funds activities. As a result, fund structures are often based on the principle of transparency. In other words, investors are treated as investing directly in the underlying portfolio companies. A common structure used internationally is the US or English limited partnership. Although based on the principal of transparency, they may not always be recognised as transparent in other jurisdictions.
Private equity investing is a long-term investment activity and for this reason private equity managers generally impose rigid restrictions on the transferability of interests in their funds. Issues of liquidity can therefore put some investors off. However, there are ways to circumvent these.
There are a number of high-quality private equity funds in Europe that are quoted on major European stock exchanges. Whilst many of these were established to take advantage of tax benefits, they remain less common than privately held vehicles. Some of the reasons for this include:
– the tendency of quoted investment companies to trade at a discount to asset value, which may fluctuate, eroding the return on investment or making it more volatile;
– the limited ability to return cash to investors – this means that when portfolio investments are realised, the cash received remains inside the fund and dilutes its performance until such time as it can be re-invested.
Still, some investors can for regulatory reasons only invest in quoted securities and for these investors quoted private equity funds remain a good option.
There is a rapidly developing market in interests in existing private equity funds, referred to as secondaries. A secondary offering may comprise a single managers entire fund of direct investments or, more commonly, a portfolio of interests in a number of different funds. There is a growing number of well-financed investors that specialize in purchasing interests in existing funds from their original investors. Generally, however, secondary purchasers do not offer a liquid or attractive exit path.
For the larger secondary portfolios, a buyer is commonly secured through an auction process. For the smaller transactions, these are often effected in a confidential manner, sometimes with buyer and seller matched by the funds manager or by an intermediary. One of the keys to a secondary transaction is securing the goodwill of the underlying manager. The manager often has the ability to refuse or restrict transfer of the interest. In addition, valuation of the underlying assets is facilitated by the co-operation of the manager. As institutional private equity programs increase and start to reach maturity, the ability for investors to realize some existing commitments in order to raise cash for future commitments will become more attractive. This will be one of the factors that accelerates the development of the secondaries market going forward.
Specialist techniques of structuring funds have more recently allowed private equity fund products to be offered with features that are attractive to particular types of investors. Through securitization, incorporated fund vehicles are able to offer interests to investors in the form of notes or bonds with credit ratings, including convertible securities. Such interests may also benefit from partial or complete guarantees of the principal sum invested. To date, such products have usually been funds of funds structured as evergreen funds, meaning that realized investment returns are not distributed to investors but reinvested within the fund. Likewise, commitments have generally been drawn down at the outset rather than on a just-in-time basis for investment. These funds are normally quoted.
Since it is not practical for many to secure diversified exposure to a variety of funds, bearing in mind the usual minimum commitment size, there are a variety of pooled vehicle types that may be offered. For example, dedicated feeder structures may provide specific single-fund exposure to private investors on a pooled basis. A variation of this model is a pooled vehicle that provides exposure to several pre-selected funds. Alternatively, investors can outsource their investment decision-making by investing in a fund of funds, such as a private bank.
Monitoring the Portfolio and Measuring Performance
An active approach to monitoring the activities of a fund holding can be a resource consuming exercise for an investor. Larger investors may be offered a place on the funds Advisory Board, which generally focuses on investor and conflict issues. Some investors will review in detail the investment case for each of the funds investments. In some instances the opportunity to co-invest may be available. Achieving a close working relationship with the fund manager is a long-term objective, which will promote a deeper understanding of the strengths and weaknesses of the manager and investment strategy. Investors that want to build a close relationship with their managers should ensure that they are able to dedicate an appropriate level of resource. For this reason, many investors will limit the number of private equity fund manager relationships that they maintain and to whom they commit funds.
Performance over time is typically measured as internal rate of return and absolute gains are measured as a multiple of the original cost. By using both measures simultaneously it is possible to illustrate the nature of returns. For example, a higher multiple combined with a lower IRR would indicate that the returns have been achieved over a longer period. Conversely, a higher IRR over a shorter period may be based on a small absolute gain. It is important for investors to be aware that anomalous and unsustainable IRRs are usually produced by uplifts in valuation that occur early in a funds life. In addition, significant realizations achieved early in a funds life will have a material impact on a funds final IRR performance even though its aggregate multiple may not be equally impressive. Thus it is always preferable to look at both measures in tandem.
The IRR is defined as the discount rate used to equate the cash outflows associated with an investment and each of the cash inflows from realizations, partial realizations or its mark-to market (the expected value of an investment at the end of a measurement period). The IRR calculation covers only the time when the capital is actually invested and is weighted by the amount invested at each moment.
When comparing a funds performance with that of other private equity funds, it is important to compare like with like. Comparing two mid-market pan-European buyout funds against each other would be appropriate. To compare sub-sector funds established during the same vintage year is also appropriate. As funds generally invest committed capital over a three-to-six year period and generally harvest investments in years three to ten, no meaning can be derived from comparing a fund in its first year to a fund in its sixth year. Also, funds with different vintage years may have experienced different economic and investment environments, which makes such comparisons inadvisable.
Whilst private equity funds do not usually publish their return data, funds of funds and consultants maintain their own databases of return information and should be in a position to make comparisons. In addition, statistics are publicly available showing aggregate quartile performance by vintage year, geography and sector.
Benchmarking against different classes of assets
The IRR computation is similar to that used to compute the yield-to-maturity on a fixed income investment. It is however different from the time weighted rate of return calculation that is standard for mutual funds and hedge funds as the variability of the timing and amounts of private equity fund cash inflows and outflows make it unsuitable. As a result, benchmarking against other assets is not a straightforward process. One method is to pick a benchmark index and to apply to a notional holding of that index the same cash flows that are experienced as a holder of an interest in the private equity fund. For example, when the fund draws down cash, it is treated as a purchase of the benchmark index of the same amount. When cash is returned, again it is treated as a realization of the same amount from the notional holding. If the fund out-performs the index, then the notional holding will have been reduced to nil before the fund finishes distributing. Benchmarking a portfolio in aggregate is also an option.
By European Private Equity and Venture Capiral Association, February 2002