Falling into a bad patch

Returns have slipped into the red, fuelling manager consolidation, writes Roxane McMeeken.

The European private equity market appears to be drying up, with poor investment returns, a dearth of investment opportunities and a slump in fund inflows seen in the past quarter. Nonetheless, the asset class still has a role to play in investment portfolios. European private equity firms raised E1.6bn in new funds in the second quarter of 2002, a fall of 70 per cent on the first quarter, according to the European Private Equity and Venture Capital Association (Evca). This reflects the fact that private equity returns have slipped into negative territory in recent months. The result, say the experts, is that investors are unwilling to make new or first time investments in the asset class. Moreover, they are trying to exit their existing investments, which is damaging private equity funds still further. However, the fall in fund inflows is in fact beneficial for the private equity industry according to Gillian Middleton, European private equity research manager at London-based Thompson Venture Economics. “If you continued fund raising at [the previous quarter’s] rate, where would you find the opportunities? It is good that the heat is going out of the market.” She adds that the consolidation among private equity managers that is likely to ensue will also improve the industry “by concentrating funds in the hands of the best managers”. But while Ms Middleton is happy for new investment to be kept out of private equity for the time being, she is not advocating that existing investors exit the market since she is confident that performance will bounce back over time. “Returns are in a bad patch, but this is only a temporary, cyclical phase. You won’t see quarter on quarter falls in performance. Even now there is still good stuff going on out there.” Keith Arundale, European venture capital leader at PricewaterhouseCoopers Global Technology Industry group, stresses that private equity is always a long- term investment, to be looked at over five, 10 or 15 years. While returns do not look good for the past quarter, from 1980 to year-end 2001 the cumulative return for private equity investments in Europe was 12.9 per cent, according to Thompson’s research. Jose-Maria Munoz, partner in Spain-based MCH Private Equity, agrees that the market is only in a temporary dip. But he says that the current market situation is leading to interesting new types of private equity deals. Particularly prevalent will be big corporations selling off non-core businesses. Mr Munoz says we will also see “turnaround situations”, where a big firm in difficulties is taken over by new owners as well as more action in the traditional sectors (non media and telecoms) than has been witnessed in the past two years. A further area to watch, he adds, is family-owned businesses, which we will now see being sold to investors outside the clan. These opportunities will arise mostly in Spain and Italy. Ms Middleton says private equity funds will also now tend to expand their investment in the existing companies in their portfolios, rather than seeking out new opportunities. Funds of funds under fire But a question mark remains over the best method of private equity investment. Ms Middleton argues that the safest bet is to go for “some of the big generalist funds, such as one run by 3i”, the venture capital giant. She says funds of funds are less advisable because the various competing firms are investing in the same underlying products, which means that the funds of funds route offers less diversification than is often thought. And less diversification means greater risk. Mr Munoz disagrees. He says, “funds of funds are set up for good reasons. There is real value in someone acting as an intermediary or gatekeeper in private equity.”