Seven years ago private equity could not put a foot wrong. Cheap debt and rising asset prices meant the industry rode an extraordinary wave, generating ever higher returns.
Academic research has showed the top quartile of private equity managers has historically significantly outperformed the public benchmark.
Hans Holmen
Scroll forwards to today and the recent failure of Comet serves as cautionary tale of how much tougher the world of private equity is when debt is expensive, the IPO market is dead win the water and the faltering economy makes the job of turning companies around that much harder.
Not only has the world changed for those providers of private equity, but changes in the regulatory environment have also changed the attitudes of many institutional investors towards the asset class.
Sanjay Mistry, principal in Mercer’s Investment Consulting business, says: “Many investors are still supportive of this asset class but they are not increasing their allocations and others are decreasing their allocations to this asset class because of regulatory pressure.”
For example, the introduction of Solvency II will make it more expensive, from a capital cost perspective, for insurance companies to hold private equity assets. “Many defined benefit schemes are now maturing and are now looking for an exit strategy with an insurance company. In this situation, it’s more difficult to hold onto illiquid assets if the fund needs to transfer the assets to finalise the deal,” says Mistry.
There is, however, one type of institutional investor who is still interested in allocating funds to this asset class and that is sovereign wealth funds. “These funds are taking up a lot of the slack. They are very comfortable with the idea of a long-term asset class and the assets they have to invest are rapidly increasing,” says Mistry.
These institutions are more likely to target higher growth as they diversify their portfolios. Traditionally the investor base for the private equity market was based in the US and Europe. While appetite for this asset class from those investors might have matured, there is still strong interest among Asian investors. “Private equity means something quite different in Asia. Rather than being more focused on buyouts, there is a much greater focus on smaller companies which are still growing strongly and which are only going through the first round of private equity ownership,” says Mistry.
While there have been some changes for the institutional investors, the operating environment for private equity has experienced a far more radical shift. To get a better handle on how the industry has been affected by the changes in the financial environment, it is a good idea to take a closer look at the private equity universe.
The faces of private equity
It is a far from heterogeneous asset class. At one of the end of the market is venture capital, which covers everything from two teenagers sitting in a garage with an idea for a new business to a company that is ready for IPO. Simon Faure, investment director at PPM Partners, says: “This part of private equity is very high risk and very high return. Funds that specialise in this part of the market will make a number of investments expecting a significant number to fail.”
Then there is the buyout market. This includes companies that need capital to grow but cannot afford the interest payments associated with debt. “Growth capital tends to be an emerging market phenomena these days,” says Faure. The buyout market also includes private equity firms either buying out all the shareholders in the company or acquiring a minority stake. “Typically these deals are funded using debt to make the returns as efficient as possible,” says Faure.
The top end of the market, when businesses are worth more than €1bn, uses relatively high levels of leverage reflecting the greater robustness of the business. “At the peak of the market, up to 70-75% of the deal was debt financed,” says Faure.
Mixed fortunes
The different sectors of the private equity market have been affected differently by the market and institutional investors’ appetite varies accordingly.
Faure says: “After the crisis there has been an increased focus on the mid-market deals rather than big deals.” That has been driven by a lack of credit and it becoming much more difficult to list companies given current risk appetite in the market. Unlike larger companies where the only exit option is an IPO, there are more options available to private equity investors in the mid-market. There are trade buyers as well as other financial investors, in particular sovereign wealth funds from either the Middle East or Asia.
Just like other parts of the investment management industry, there are those managers which have emerged stronger from the crisis and those which have seen their fortunes dwindle. “The returns for the top quartile of managers have been respectable during the financial crisis,” says Hans Holmen, senior consultant of private equity and infrastructure at Aon Hewitt. “Academic research has showed that the top quartile of private equity managers has historically significantly outperformed the public benchmark.”
Managers, which have a compelling strategy and can add value to their portfolio by making operational improvements to the companies they’ve bought, generally perform well. And companies which have used a more conservative financial structure have been able to cope well with the difficult economic environment in the US and Europe, adds Holmen. Investors have become much more discerning about where they invest, focusing only on those managers with the best track records. Faure says: “Only the largest funds of private equity funds are finding it easy to still raise money.”
Private equity is the pinnacle of active investment management strategies so the key to success for investors is the ability to select the right manager. Holmen says: “The skill is to pick the top quartile managers of the future.”
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