A spacial place in any portfolio

Private equity presents the opportunity for tremendous profit but investors are often concerned about the risk. Jonny Maxwell, chief executive of Standard Life Investments (Private Equity) outlines the promise and the potential pitfalls of investing in this attractive asset class.

To many people, the term “private equity” conjures up images of either finding the next Microsoft in the next-door garage, or corporate bankers dressed in Versace suits, smoking cigars and mulling over their next big deal. Put simply, private equity relates to an investment strategy that involves the equity in a company not listed on a stock exchange. Studies have shown that private equity returns do not correlate closely with returns from other asset classes, such as bonds and public equities. Having an allocation to private equity therefore can help smooth out the returns of a balanced portfolio. Private equity finance is provided by firms who themselves generally raise funds from investors such as pension funds, financial institutions, charities and endowment schemes. The companies that these private equity firms fund cover the whole spectrum from high-tech companies through to established, old-line manufacturing firms. However, despite the wide range of industries, all private equity deals have key features in common – sophisticated financial investors, highly motivated managers and the prospect and opportunity for both groups to make lots of money. To achieve this ambition, investors and managers have to work together to create value by improving the profitability, growing the sales or purchasing related businesses and combining the pieces to make a bigger company. Private equity firms point to numerous factors that make the asset class attractive. Most obviously, the investment returns can be high, although not without risk. In addition, information can be more easily obtained and due diligence more effectively undertaken than with listed companies. Pricing volatility is lower, timescales can be set by company management rather than market sentiment, and, most importantly, the collaboration of management and private equity investors control a company’s destiny. It is not dictated by the vagaries of the stock market. Performance The explosive growth in the popularity of private equity in the past 10 years has been due to a number of factors. Investors have shifted from fixed income to equity investing, there has been proven outperformance in private equity compared with many other markets and asset allocators have become less conservative. For a number of reasons, going into private equity funds directly is difficult for individual investors. The premier private equity funds are inaccessible to all but the highest net worth investors. As with all good parties, these funds are often “by invitation only”. The only way to access this particular party is either by charming the private equity group for an invite, or to use an experienced and respected fund of funds manager who will have the background, contacts and experience to be on the guest list. Investors and their intermediaries should beware of some of the popular private equity myths. All private equity managers will claim a proprietary deal flow and a unique investment strategy. All will say their track record ranks among the top 25 per cent of managers, and almost all claim to add value in the “post transaction”, “pre realisation” phase. The selection of the fund manager is the overriding decision and requires thorough due diligence. Do they have the core competencies, the research capability, a cohesive team, the experience they claim and real contacts? How do they compare to other private equity funds? How do terms compare? Due to the complexity of the decision process, private equity fund of funds have grown rapidly in popularity in recent years. The fund of funds manager effectively co-mingles the investible assets of many investors into a single vehicle, and invests this pool of money to assemble a diversified portfolio of private equity funds. At Standard Life Investments, our private equity focus is on Europe, where we believe there continues to be enormous opportunities available, particularly in middle market management buyout transactions of between E50m and E500m. Studies have shown that the average performance for private equity funds in the three years following a downturn can be as much as 57 per cent greater than for the three years prior. In a cyclical downturn, companies are more inclined to dispose of non-core assets in an effort to maintain profits and they are usually willing to do so at depressed prices. Management buyout investors can generally find very attractive deals during these difficult times. Climate As a sign of our confidence that the current investment climate is extremely attractive, we are currently raising a €1bn private equity fund of funds, European Strategic Partners II (ESP II), which is mainly focussed on medium sized buyouts in Western Europe. Our parent company has committed €500m to ESP II and we will shortly have a first close on commitments from both new and existing investors. European private equity has lagged behind the US and remains relatively underfunded, some have suggested by as much as 70 per cent. The reduction in cross-border barriers to trade and investment, allied to the introduction of the euro, has encouraged capital from many sources to seek returns from private equity. We look for managers who have established track records, have known bad times as well as good and have a realistic approach to business and business models. We also like being managers that add value to their investments. Private equity is generally considered to be a high-risk, high-return asset class that can enhance the overall return of a well-diversified investment portfolio. The main concerns that most people cite are the lack of liquidity, the loss of control, the business cycle and manager risk. The lack of liquidity is less of an issue than it might appear. If you invest in private equity through an investment trust (a fund of private equity funds) listed on a stock exchange, you can buy and sell the investment in the same way as any other share. If you are able to invest in funds directly, there is a fairly strong secondary market for private equity funds with several leading players focussing exclusively on this sector. In unlisted investments, professional private equity managers are able to negotiate rights often unavailable from listed investments, ensuring control of specific corporate events, activities and spending. These rights are commonly included in the contracts concluded at the point of acquisition. The risks in the business cycles of private equity investments are just the same as in any other asset class. The biggest risk is investment manager risk. This can be avoided by leaving manager selection to the experts. It is all about due diligence. The incremental cost of using a specialist for manager selection is dwarfed by the profits you earn from being right compared to the enormous cost of getting it wrong. Experts So is private equity more risky than the listed markets? I think the shareholders of companies such as Marconi and Enron will tell you about the high risks in listed markets. It is not the asset class that provides the risk, it is the success, or otherwise, of each investor’s individual strategy that will determine performance. Private equity has a place in many portfolios, but it is generally best practised by experts. Make sure, when considering an investment, be it in a trust or fund of funds, that your preferred manager has the experience to make informed, balanced and reasoned decisions based on process, due diligence and professional judgement. This will help minimise losses and hopefully generate the profits investors have come to expect from this most interesting of asset classes.