Public access to private equity

The traditional partnership model of private equity funds puts up formidable barriers to entry: investors are lucky to get into a direct fund for less than $10m (E6.8m), locked-up for as long as 15 years; funds of funds let investors in at around $1m, but the prized relationships in what is a very relationship-driven business are with big institutions who have slots lined-up months ahead of fundraisings. But with its liquidity premium and long-duration cash flows, the asset class is well-suited to retirement planning, and the growing global entrepreneurial class, which makes up an increasing proportion of wealth management clients, wants a piece of it. Listed, closed-ended vehicles – open to anyone with a stockbroker, with minimum investments of one share and daily trading with exchange-quality transparency – could be the answer. “You can buy into these things today and you’ve immediately got yourself a private equity portfolio,” enthuses Jeremy Beckwith, chief investment officer at Kleinwort Benson. “We’ve always believed that listed private equity is right for the individual,” agrees Andrew Lebus, a managing partner with Pantheon Ventures, who manages the oldest listed private equity fund of funds, Pantheon International Participations plc (PIP). “We’ve been very active in talking with the wealth managers and private client stockbrokers, and we would like to see PIP become a more established feature on their buy lists.” A recent survey of 33 wealth managers by the Initiative for Private Equity Investment Trusts (iPEIT) and ComPeer found that 24 of its 33 participants had listed private equity holdings (LPE) while only eight were in Limited Partnerships (LPs). Thirty-eight per cent of those holding LPE expected to increase their allocation this year and only 13 per cent are bringing theirs down. They were also taking a diversified portfolio approach: the median number of LPE holdings among participants was six (up from five the previous year), comprising both direct funds and funds of funds. A private client buying shares in each of the 22 LPE funds of funds currently on the market gets exposure to literally hundreds of underlying funds – with surprisingly little overlap – diversified (or concentrated) across investment stage from venture to buyout, across vintages dating back 10 years, across geographies and sectors.

‘You can buy into these things today and you’ve immediately got yourself a private equity portfolio’ - Jeremy Beckwith, Kleinwort Benson	‘I think they will all be quite surprised by the amount of management they require ’ - Andrew Lebus, Pantheon Ventures

Minimum investment levels are not the only obstacle to replicating that strategy in the LP context. “In traditional partnerships you commit the capital and then it’s gradually drawn down on a six-monthly basis,” says Paul Hooker, investment trust analyst at Kleinwort Benson. “You have to manage those cash drawdowns, and if you’re doing this for a number of funds that can be quite complicated.” In the “permanent capital” context that headache gets outsourced to the fund manager – but investors should remember that that is an important transfer of responsibility: cash-management is also j-curve management, referring to the shape of a graph where money is automatically lost in the first few years, because it takes time to invest the cash. “How the manager deals with uninvested cash would certainly be an important part of our due diligence,” says Mr Hooker. “Cash drag can kill performance pretty quickly.” LPE fund of funds providers manage cash drag in a number of ways. Pre-IPO, they now tend to warehouse assets so that the fund can be near-fully invested from day one: the December listing from Harbourvest was 98 per cent invested within four weeks. Once up-and-running, the shares reference permanent capital that is constantly churning into new investment opportunities and secondaries as gains are realised from older vintages (which themselves would have been long-closed to new LPs), and most funds of funds now do this using an over-commitment strategy. PIP was one of the first to introduce such a mechanism when it re-organised its balance sheet in 2000: its latest net asset value (NAV) is £685m (E910m), but it also has outstanding, unfunded commitments worth some £560m ready to suck-up distributions as they come in, with a bank facility ready to bridge any gap caused by timing differences. The fund used to have up to 30 per cent in cash on its balance sheet, and now it has virtually none at all. “Experience counts for something in this – it took us 13 years to work it out,” says Mr Lebus. “Some of these vehicles are managed by very good houses, but I think they will all be quite surprised by the amount of management they require.” But as the end investor waves goodbye to the cash-management headache, he must say hello to another: the fact that shares can trade at a discount or premium around NAV. Since the credit contraction shares have dipped from trading at premiums of 5-6 per cent to discounts ranging from 17 per cent in London to a whopping 25 per cent on Euronext. “We do think boards need to look at structural ways of addressing the discount,” says Mark James, executive director with ABN Amro’s Global Investment Funds Team. So what could they do? In theory, they can buy back shares themselves. Like all public companies, they can take 15 per cent out of the market, and in the listed hedge fund sector this sort of discount-floor mechanism has been freely applied – indeed, some have employed discount-to-NAV arbitrage as part of their investment strategy. Private equity seems to do things differently – not least because managers already starved of secondary-market liquidity do not rush to mop it up themselves. “We have the 15 per cent facility,” says Mr Lebus. “But our stated policy is to use up to 1 per cent of our assets to buy back in the market, and I think you would find that buybacks in the private equity sector are quite uncommon.” Mr Beckwith accepts that, and, like many other wealth managers in the iPEIT survey, he even feels that the discounts “might provide an attractive entry point”. Louisa Symington-Mills, an analyst at ABN Amro, agrees, but cautions against simply ignoring the structural problems: “Although we believe the sector has been oversold, we are not expecting these companies to return to par within the next few weeks,” she says. “There are still issues around pricing efficiency, and there is a general perception problem around private equity at the moment.”

One could add that there is a general perception problem around equity – let alone private equity – and that raises important questions about how much public market beta leaks into your private equity allocation if you take the LPE route. As KKR Private Equity Investors CFO Kendra Decious put it when asked about her fund’s discount: “To reverse a popular saying, a falling tide can lower all boats.” That won’t really do in an environment where more and more wealth managers are allocating to LPE under alternatives, as opposed to equity, as the iPEIT survey found. Over the longer-term, discount-to-NAV in these vehicles can probably be disregarded – Alice Kain, investor relations director for SVG Capital, says that her fund’s 3-year correlation with the FTSE All Share index is just 0.55 - but over a shorter, 12-24 month view it can clearly be an issue. The only way to smooth some of this out and help prices stay closer to NAV is to improve the secondary market, but despite the record-breaking May 2006 listing on Euronext by KKR Private Equity Investors, there is still much to be done to make LPE better-known outside the specialist investment-trust community. “On paper, this sector has been around for a very long time, but in reality the growth of the industry has only just begun,” observes Ms Symington-Mills. “Of the 22 funds of funds, 10 listed since May 2006.” Mr James notes that investment banks have been quick to get involved in the primary market. “But as we move into a more uncertain environment banks need to follow-through and offer secondary support, in terms of research, secondary sales, corporate broking and so on. We’re not there yet.”