Taking a second look at private equity

Alexander McNab looks into the private equity market and explains the risks, potential upside and misconceptions that accompany the sector.

Private equity is an asset class that is familiar to most institutional investors – major institutions have long used an allocation to private equity as a way to enhance returns and reduce overall portfolio risk.

Recent changes in the Australian wealth management market are leading to an increasing focus on private equity among individual investors and financial planners, and allocations to alternative investments (and private equity in particular) are rising.

This creates a need for a greater level of understanding about the asset class, its risk and return characteristics, and the role that it can play in investors’ portfolios.

What is private equity?

As its name suggests, private equity involves investing in private companies (ie, those not listed on public equity markets like the Australian Stock Exchange).

Private equity includes a range of investment strategies (including venture capital, leveraged buy-outs, and growth capital), all of which share three common characteristics:

• Investing in private companies allows private equity managers to take a medium-term view on business performance. Investee companies are not subject to continuous disclosure or half-year reporting requirements, so management teams can make decisions that are in the long-term interests of the company, without fear of short-term share price fluctuations;
• Private equity investors take meaningful equity stakes in the companies in which they invest, exercising significant influence over the strategy and operations of the business, and taking board seats to oversee and control the company’s performance; and
• Private equity investors invest with a medium-term exit horizon, planning to hold the business for three to five years before selling the business at a profit.

Private equity: risk and return

Private equity has historically generated strong returns for investors.

As table 1 shows, Australian private equity managers have achieved higher returns than both the S&P/ASX 300 Index and the S&P Small Ordinaries Index over one, three, five and 10 year periods.

The superior returns from private equity investment in Australia are consistent with the experience in other markets, and underpinned by three features of the private equity model:

• A robust investment process that involves rigorous due diligence on potential investees;
• An active approach to investing, with private equity managers actively guiding the businesses in which they invest; and
• The ability of private equity managers to attract high quality management teams to the businesses in which they invest, and to align their rewards tightly to the success of the business.

A feature of private equity investing that distinguishes it from other asset classes is the importance of manager selection.

Private equity exhibits a much greater ‘dispersion of returns’ (ie, the difference in returns between top quartile and bottom quartile fund managers) than other asset classes.

In addition, private equity features ‘persistence of returns’ (where top quartile fund managers tend to remain in the top quartile over time).

This persistence of returns is in contrast to listed equity fund managers, where managers tend to revert over time to the performance of the index.

This combination of dispersion and persistence of returns makes it important for investors to select private equity fund managers carefully.

Another key difference between private equity and other asset classes is the liquidity profile of the investment.

Private equity funds invest in private companies with a three to five year exit horizon, and as a result are illiquid and closed-ended.

Investors considering an allocation to private equity should ensure that their overall portfolio construction provides them with sufficient liquidity to meet their likely personal circumstances.

Private equity has an important role to play in the portfolios of institutional and high-net-worth investors.

In addition to generating superior returns, private equity introduces an important element of diversification in portfolios – with returns being relatively uncorrelated with public equity markets.

As a result, an allocation to private equity can enhance overall portfolio returns while reducing overall portfolio risk.

Some common misconceptions

Private equity is an asset class that attracts a significant amount of media attention, not all of it balanced or well informed. As a result, a number of misconceptions about private equity have arisen.

1. Private equity is only for institutional investors

Historically, private equity was the preserve of institutional investors and ultra high-net-worth individuals. Institutional investors have long seen the return and diversification benefits of alternatives (including private equity), and global institutional allocations to alternatives are expected to increase to 20 per cent of overall portfolios by 2012, with private equity making up one quarter of this allocation to alternative investments.

However, private equity is also becoming an increasingly important source of returns and diversification for individual investors.

Globally, high-net-worth investors are increasing their allocations to alternatives (including private equity) from 6 per cent to 8 per cent of their portfolios.

In Australia, this trend is being reinforced by the increasing prevalence of SMSFs, where investors with relatively large superannuation balances are looking for opportunities to diversify outside conventional equities, property, fixed income and cash allocations.

Private equity fund managers are responding to these important changes in the market by broadening their fundraising strategies.

More and more private equity managers are exploring ways to introduce their offering to a broader range of investors, including SMSFs, high-net-worth individuals and financial planning clients.

Leading financial planning groups are increasing their allocations to private equity, and independent research houses are beginning to provide ratings on retail private equity funds.

Over time, this will improve access to private equity funds among financial planners and their clients.

2. The GFC was hard on private equity

The global financial crisis (GFC) was a testing time for investors across many asset classes.

It is commonly believed that private equity was an asset class badly affected during the crisis, perhaps due to the number of high-profile private equity investees that experienced financial distress.

While private equity was not immune from the downturn in conditions, recent performance data does not support the view that private equity was worse affected than any other asset class.

In fact, as the performance data previously quoted demonstrates, private equity has outperformed both the ASX 200 index and the ASX small caps index during the GFC.

Additional research from the US suggests that private equity-backed companies weathered the GFC better than other businesses.

According to Bain & Company, the default rate in for private equity backed companies was less than half that of other companies with similar credit ratings.

3. Private equity is a debt-driven model

Private equity is often perceived in the market as an asset class that relies on high levels of leverage to generate returns.

However, a detailed analysis of private equity returns from 1989 to 2006 conducted by Bain & Company indicates that only one-third of returns from private equity were attributable to leverage.

The primary driver of returns over that period was from increases in the operational performance of the underlying businesses and, less importantly, increases in earnings multiples.

On the up

Private equity as an asset class has a long history of enhancing returns and reducing portfolio risk for institutional investors.

However, with recent changes in the Australian wealth management market, the profile of private equity is increasing among individual investors and financial planners.

This is being reflected in greater allocations to private equity across this segment of the wealth management market, a development that will most likely work to the long-term benefit of an important set of Australian investors.

Alexander McNab is a strategy director at Blue Sky Private Equity.