Allowing investors a smaller bite of the private equity apple

In today’s markets, illiquid investments such as private equity can significantly enhance returns in clients’ portfolios. “The premium and the cost for liquidity have never been higher,” says Rhian Horgan, international head of alternatives at JP Morgan Private Bank.

“In an environment where cash is yielding less than 1 per cent and equity markets remain volatile, significant yield enhancements have been provided by the private credit market. Also, private equities are continuing to outperform public equities,” she says. “In the private equity space we are looking to earn between 5 and 10 per cent per year on a compounded basis in excess of what you can earn from public markets.”

Illiquidity in private equity, where investors’ money is generally locked in for 10 years or more, is always going to be a concern. “The question for clients is how much illiquidity they can tolerate and what the cost of not tolerating any illiquidity is. When cash rates are very low, there is a huge cost for liquidity. Investors really have to think about how much liquidity they need in their portfolio.”

Through private equity, it is possible to gain exposure to opportunities not accessible through public markets, explains Ms Horgan, with emerging markets including some Asian countries and also Brazil, offering particularly good potential.

“We are very optimistic about the opportunities in private equity in Brazil,” she says. “We are fundamentally bullish on Brazil, where we have seen a decade of prosperity and stability.”

However, 50 per cent of its public market is comprised of eight stocks, which are mostly financials and a few large commodity players. “If you really want to get access to the domestic growth story in Brazil, you will have to do it through the private markets,” she says.

Private equity opportunities are also found in the technology sphere, which has proved to be a recession resistant sector. “Consumers were more likely to give up going out to eat than to give up on their mobile phones,” says Ms Horgan.

But there are tremendous changes happening, she explains. “There are a lot of winners and losers in the technology space, and there are many opportunities which aren’t very economically sensitive. A lot of interesting private companies haven’t gone public yet, so in order to be involved in some of these emerging technologies, you need to make private investments before the companies go public.”

Energy is another interesting sector, even more crucial in light of the Mena crisis and the world’s tightening of reins on nuclear power, provoked by the nuclear disaster at the Japanese Fukushima plant. “If you believe in the emerging market growth story, you can see how demand for energy is going to grow quite dramatically over the next 10 years,” says Ms Horgan.

“While there are certain sectors where there is strong supply growth, such as coal or gas, there are other places, in particular nuclear, which are much more restricted,”

A very high volume of M&A activity is taking place in the energy space, with more than 2,600 M&A deals globally during the last five years, of which the large majority, 2,300, have been small transactions worth less than $500m (€350m).

The fund of funds route

The traditional hurdle with private equity investing is the very high minimum threshold to get into funds: minimums are as low as $1m but they go as high as $25m, so a medium to high net worth investor, in order to get the appropriate diversification, will generally need to go through a fund of funds, rather than the direct fund route.

“Clients who are putting $10m to 20m to work in private equity have enough capital to build out diversified portfolios themselves, whereas if they put $2m or $3m into private equity, a fund of funds makes more sense,” says Ms Horgan.

Because of the illiquidity associated with these investments, and as many of them are private placements, there are strict regulations around what types of investors can invest in these strategies. Typically, clients need to be worth more than $5m, in order to be deemed to be eligible to invest.

One of the reasons why the entrance thresholds are so high is that private equity firms have historically been built around investment professionals or deal makers, rather than a team of client servicing professionals, explains Ms Horgan.

“Over time private equity firms have built up more people to interact with their limited partners (LPs) but the reality is that most of these managers have a lot more resources dedicated to investing than client servicing. That’s why you don’t tend to see them accepting investments typically less than $10m in their funds. In fact many managers have minimum investment size of $25m or more.”

In that sense, a partnership between managers and private banks creates good synergies. “We have great relationships with our clients, we do the due diligence on funds and then we provide the monitoring and the servicing of the investments that our clients make. That gives us the flexibility to then allow clients to invest at smaller bite sizes in these funds,” says Ms Horgan.

Sub-advisory solution

Those private banks that do not have the capacity to select private equity funds in-house and do not see value in building an in-house team may decide to outsource. Goldman Sachs Asset Management had identified a clear trend towards sub-advising the portfolio construction and asset allocation of funds of private equity funds, especially from private banks.

In return for the extra fees, private banks or wealthy investors get fund diversification and high quality professionals working on creating a bespoke fund for them, access to funds they might not otherwise know of or be able to get into, plus due diligence, monitoring, risk management and reporting, explains Charles Baillie, co-head of the Alternative Investments & Manager Selection (AIMS) Group at Goldman Sachs Asset Management.

“High net worth investors are more interested in concentrated portfolios, they are much more thematic based than institutions, they are much more interested in brand names and they love the hard to access story,” explains Mr Baillie.

High net worth clients’ portfolios are generally more concentrated – investing in ten to 12 funds, as opposed to the 20 of typical institutional investors’ portfolios – and these tend to be funds with a more proven track record. “It is less likely that we’d put in first-time funds, for example,” he says.

Unlike most private equity firms, Fleming Family & Partners Private Equity (FF& PPE) offers high net worth investors direct access to its private equity fund invested in low and mid market growth companies in the UK.

The single fund route meets investors’ growing desire to be more involved in the management of their money. The crisis exacerbated this need, as people ended up in very illiquid funds, in fund of funds structures, where they had very little ability to speak to the underlying managers or understand what the rationale for the fund to return its capital was, explains David Barbour, co-head & director, at FF&PPE. This has made people more wary of fund structures. Also in the downturn, people get more wary of fees, he explains.

“There is quite a strong desire amongst high net worth individuals to have a more transparent and direct relationship with the private equity in which they are investing, particularly to be able to have more communication with the managers, maybe even to the extent of meeting the underlying companies occasionally,” says Mr Barbour.

This is particularly true for people who have made their own money. “Entrepreneurial wealth is very business savvy and wants to be able to have those kinds of conversations and input,” he says.

“They find the distance the fund of funds model puts between them and the eventual investment a bit frustrating, and when things go wrong, quite annoying.” 

For Fleming’s latest UK private equity fund, the minimum investment has been lowered to £250,000 (€400,000) from its historical £500,000, but it now gives the possibility to investors to make a ‘discretionary investment’ on top of the investments the firm makes. “If investors really like the company, they can have an extra percentage of that business,” reveals Mr Barbour. “That way, they can almost tailor their portfolio, so that it has a strong weighting towards the companies or the sectors they like. A lower minimum would allow them to keep some ‘dry powder’ to invest in those opportunities,” he says.

But most private equity firms don’t have the office capability to handle the administration of a large number of individual investors, and they don’t have the culture of doing it, explains Mr Barbour. “The families who invest with Fleming Family and Partners have always had a certain amount of co-investment in our funds. It is a relatively small step to formalise that into this kind of co-investment approach.”

Selecting managers

A strong team, a coherent strategy, historical track record, deal flows in the past and alignment of interests are key factors to evaluate when selecting private equity managers, explains Charles Baillie, co-head of the Alternative Investments & Manager Selection (AIMS) Group at Goldman Sachs.

But what is also important is to make sure the fund terms protect the investors, should anything go wrong. This feature is particularly relevant in emerging markets, which offer significant growth potential. Private equity really did not exist in the growth markets such as the BRICs (Brazil, Russia India, and China) and now the size of the BRICs market is $30bn. Returns in private equity in the emerging markets have gone up 3 to 4 fold over the last decade, relatively to the previous decade, says Mr Baillie. But risks are higher too because of the limited track record and minority stakes in companies.

“In private equity, one of the things we really look for is the ability of a private equity firm to control the company, ie to control more than 50 per cent, so they can go in and operationally improve the company and drive value,” he adds.

In emerging markets, more than 80 per cent of the deals involve minority owned companies, largely because the government might own some, or the founder does not want to sell out in the expectation of future growth. “Generally the deal structures allow for less control. So you have got to put in place a series of legal structures that make up for that.”

Having incentives aligned is so much more important in the private equity space than in other asset classes, because the investor is really betting on a theme to create value for 10 years, as money is locked in and there is no real benchmark to follow, explains Mr Baillie.

For example, there is alignment of incentives when the general partners invest a considerable amount of their own money in the private equity fund and the compensation is generally fairly divided amongst the team, in order to prevent part of the team leaving to start their own fund.

A long track record is important, but it is not essential. Mr Baillie explains that they also invest in a number of funds set up by talented managers who worked for big firms, such as Goldman Sachs itself, and decided to leave to set up their own private equity fund. Opportunities can also be found in smaller funds, which may be only $200m in size, but focus on a unique business area, or they are expected to generate good returns. But in general, high net worth individuals don’t get quite excited about these kinds of funds, he says.

“I think the current environment is clearly favouring funds which have demonstrated a strong track record, but equally important is how the returns have been achieved. A consistent performance across the underlying portfolio companies with returns driven by strong company performance is key for investors,” says Robin Winning, partner at specialist private equity fund management and advisory business SVG Advisers.

“What we are seeking from the managers we back is evidence that they have adapted to take greater account of downside scenario planning and risk management in this changed environment,” he says.

In the current economic climate, the best managers will achieve their gains through operational change within the businesses they buy, and that may come from more M&A activity, consolidation of industries or restructuring of businesses.

“This environment offers great opportunities for M&A, in terms of consolidation of more fragmented industries for private equity players to buy weaker competitors within their market for example. We look for evidence of managers who have successfully implemented those kinds of strategies in the past, but equally are able to identify businesses which are responding and adapting well to the current economic environment.”

The current environment for private equity is one of the most positive seen for quite a number of years. SVG research shows private equity managers responded with speed to the downturn and strengthened their portfolios.

“One of the risks was around the ability of portfolio managers to manage the levels of debt within the portfolio companies they held. Many of those managers and underlying management teams very successfully restructured the debt, pushed maturities out and strengthened the balance sheets of businesses within their portfolios.”

There is a today a stronger polarisation between the strongest managers and those with less success in managing assets they have invested in. “As we enter this next phase of fund raising, we will see a concentration of fund raising success amongst the best managers,” he says.

Fundraising environment

In the good years of 2006-2007, a record amount of money was raised in private equity, but the crisis has dramatically brought a halt to private equity fund raising. That trend has reversed in recent times. “We are starting to see interest pick up again as people re-risk, and move from crash to debt, from debt to equity, and from equity to private equity,” notes Mr Baillie at Goldman Sachs.

Wealthy individuals’ capital came back into the market much faster after 2008 than institutional money, says Ms Horgan at JP Morgan Private Bank.  “In the last couple of years we have seen a lot more private client capital that’s been committed to these investments than typical institutional capital.”

Private clients generally can move faster, because one or two people are making a decision rather than a quarterly investment call, she says. A lot of the institutions, particularly US endowments and foundations, were massively over-allocated to private equity, they had liquidity constraints and they were not able to make new commitments.

“Also structurally, private clients think about these assets in the context of their overall portfolio, whereas at times institutional investors tend to think in very ‘siloed’ fashion: most of them didn’t invest in private credit opportunity, because it didn’t really look like private equity or public credit and so they weren’t used to analysing it.”

Equally, private equity deals have been picking up and deal activity in 2010 was twice that in 2009, and this year has started very fast. Some of the deal activity has been driven by the fact that private equity firms, which have invested slowly over the past two to three years, will start feeling under some pressure, says Mr Barbour at Fleming Family & Partners Private Equity.

Private equity funds are set up on the basis of the five-year investment period: investors commit funds, but the money that is not invested at the end of the five years is reverted to them and no longer counts as a commitment, although the amount invested remains invested in the companies.

Private equity firms are selling to each other in many cases. Eight of the largest ten largest private equity exits in 2010 were with other private equity firms.

As at September 2010, it has been estimated that there is $281bn of ‘dry powder’ in European private equity, ie commitments made by investors which have not yet been invested. But according to some analysts, a lot of them are happening at quite high prices, and that is not necessarily positive for the investors.

In fundraising, there are peaks and troughs, says Jonathan Blake, senior partner at law firm SJ Berwin. “It is natural that after a few years where private equity firms haven’t raised the fund, if they’ve only got a five-year investment period, then they are more likely to be more coming to the market to raise funds in the next 12 months.”

Routes to private equity

Probably the main way in which individuals participate in private equity funds is as pensioners though pension funds, which are one of the largest categories of investors into private equity funds, estimates Mr Blake at law firm SJ Berwin.

Private banks tend to establish feeder funds for their own clients, where they put together a group of their own private clients into a pool and then invest that pool into a fund, as if that pool were an institution.

Also popular are private equity clubs, where underlying investors joins a club, may pay an annual fee and might receive a regular circular of deal opportunities, which they have to respond quickly and then make a decision. “Some of them are very effective, certainly some of the professionals in the private equity market themselves invest in these clubs,” says Mr Blake. “They tend to be more like angel clubs, they invest in start-up, technology and are high risk.”

But Mr Barbour at Fleming Family & Partners Private Equity believes this model is generally not successful. “If the investor does not have a committed fund with the manager, it is quite difficult to tie down the best deals.”

Wealthy individuals join the club

A number of options are available to high net worth individuals who want to invest in real estate. In the fund space, they may decide to invest in funds investing in actual property assets or in funds that invest in property companies, listed or unlisted.

However, most investors like to invest directly in bricks and mortar. Club deals are increasingly more in demand, where a number of individual clients invest directly into the one deal. This way they are able to gain access to properties they would not be able to access on their own and they can the risk. It is becoming important for private banks to be able to facilitate syndicated deals.

Club deals are one of the recent developments at HSBC Private Bank, which offers them through HSBC Alternative Investments. “We believe this is a key offering to our clients,” says Daniel Ellis, head Private Bank Investment Group UK & Channel Islands at HSBC Private Bank.

Early this year, the private bank has completed two syndicated deals with two buildings in Washington and it has other deals in the pipeline.“We are positive on prime locations, we have seen very good interest for the deals we have offered so far this year and we see syndicated deals particularly important going forward,” says Mr Ellis.