Private equity: Private risks, public opportunities

The outlook for the private equity sector.

Hamish Mair, Manager, F&C Private Equity

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Private Equity as an asset class is rarely out of the news, but, ironically, it is a mode of investment management that is unfamiliar to most stockmarket participants. Because it involves investing in companies that are not listed on the stockmarket, the amount of publicly available information about those companies, the funds that contain them and the managers that run the funds is far more limited than for most other branches of the investment management industry.  Of course, this is where the key attraction of this asset class lies - in the market inefficiency that an absence of publicly available information creates. In private equity finding out about the prospects of a target investment is a long and laborious process where a Bloomberg terminal or broker’s research note will be of limited, if any, use. It follows that those who seek hardest and look closest can often find an opportunity that others cannot. Indeed since private equity is usually done through a negotiated transaction rather than over an exchange with predetermined rules and procedures, the investor has the chance to create an investment that suits their specific return requirements and time horizons. Every deal is to a large extent a one off.  Because of this and the general ‘behind the scenes’ approach it is only at the entry and exit of deals that private equity usually enters the public domain.

All of this inefficiency brings with it risk as well as opportunity and that is why private equity investors quite correctly demand higher returns than could usually be delivered from the stockmarket. Typically, the starting point is at least 5% per annum better than the equivalent stockmarket index over the long term (i.e. 5 to 10 years) and for many it is considerably higher. The risks are obvious – firstly there is no liquidity with the exit of an investment requiring a negotiated transaction with many inherent risks and substantial costs. Because private equity is often associated with implementing positive change in a company, it requires time – usually at least 4 years – and with this comes more risk. Then there are the risks associated with the smaller size of private equity companies - although some deals are measured in the billions – and with the higher levels of gearing that are usual in its popular format the management buy-out.

These risks can be addressed by the control that comes with majority or influential ownership. Private Equity is an unusually hands-on style of investment with the private equity managers normally sitting on the boards of investee companies and being closely involved in the strategic direction of the investments. To be done successfully it requires not only the skills of judgement that are critical to any form of investment management but also the skills of operational execution, which usually reside within the managerial rather than investment sphere. Bringing all these factors together successfully and consistently against a background of risk and subject also to the vagaries of the market beyond the company is difficult and the managers who can achieve this are comparatively rare.  Importantly the strongest private equity managers make excellent returns no matter what the economic conditions or stockmarket performance, which is why this should be viewed primarily as an absolute return asset class.

Finding the best private equity managers within a given market is not as easy as it may sound. Although the persistence of outperformance in private equity is good – a by-product of market inefficiency - track records take many years – even decades – to build up and in some cases by the time they are measurable the opportunity to participate has gone! Just to add to the difficulty, track records are sometimes presented in a ‘selective’ format with the less good ‘off strategy’ deals excluded from the initially presented numbers.

Private equity benefits from a very powerful alignment of interest between the investor, the managers of the fund and the management of the investee companies. When one succeeds, all succeed and vice versa. The rewards for successful private equity managers are as good as the capitalist system can offer anyone, although it will usually take a couple of decade’s worth of toil for any of this to be manifest.  However finding suitably skilled, experienced and motivated managers with whom to invest is surprisingly hard. The difference between the best and the worst investors in private equity is vast – with the excellent ones delivering 40%+ IRRs over several years and the worst losing all or most of their investors’ money, again over several years during which they will charge a handsome fee. Distinguishing between these categories is not aided by the plausibility of most private equity managers.  The differences between top performers and disappointing ones are subtle and are usually not apparent upfront to the non-expert.

To capture the high returns of private equity through selecting the managers and therefore the funds with the best prospect of success whilst reducing the innately high risks to tolerable levels is the ‘raison d’etre’ of the private equity fund of funds sector. For the investor in listed shares there are several available including F&C Private Equity Trust Plc. This trust has an international portfolio comprising approximately 75% funds and 25% co-investments with an emphasis on mid-market European buyout funds. Within this, it has a deliberate policy of seeking out and backing promising emerging managers.  Since its establishment in March 1999, it has delivered an NAV total return of 232.43% and a share price total return of 195.54%, to 30 June 2014 (latest reporting date). Investors in this trust gain exposure for the price of a share to over 50 private equity managers with nearly 400 underlying companies internationally. A publicly accessible way to participate in the enticing world of private equity.