Investors venture into private equity

Venture capital has become a hot topic in the last few years. Fuelled by the extraordinary run in NASDAQ listed technology stocks, many of the venture capital backers of early stage businesses that skyrocketed into prominence generated exceptional returns from the tech boom.

While the boom has gone and a lot of the method underpinning dot com valuations has proved to be hyperbole, the result has been a much higher level of interest in the venture capital market.

This interest has particularly been from retail investors wondering whether and on what basis they can have an exposure to this asset class.

The extreme volatility of the last two years highlights the potential for variable returns. But it also obscures two very important points about this asset class.

The first of these is that dot com investments in venture capital are but one segment of a broad asset class best described as private equity.

This includes investments ranging from early stage companies through to expansion capital for growing businesses and management buyouts, frequently of large scale, mature companies.

The second point is, as the chart demonstrates, over long periods of time returns from private equity can significantly outperform other asset classes.

The term private equity is a generic name for investing in a range of mostly unlisted businesses in various stages of development.

Earlier stage businesses have a commensurately higher risk offset by outstanding returns for those that succeed, showing annual rates of return of 40 per cent and better.

Expansion and later stage funds aim for more consistency of returns but at a lower rate of return normally in the range of 20 - 30 per cent.

The performance of quality private equity funds managers over the long term (10 years and beyond) is strong, with net returns to investors in excess of 20 per cent not unusual.

Reflecting the nature of the businesses in which they invest however, investments in such funds are normally quite illiquid, with returns deferred and irregular.

While an exposure to private equity may be a sensible diversification strategy for retail investors they should be comfortable with the exposure to risk in relation to return of capital. They should also be suited to an investment which is illiquid and which has no established secondary market and an upside which is based on capital growth over a 10 year period.

Providing prospective investors are comfortable with these parameters, an exposure of five to 10 per cent of a total portfolio for high net worth individuals may represent a sensible investment strategy.

The Australian private equity market has been through a dramatic period of growth since the early nineties, with the number of venture capital firms growing from 43 to 135 since 1993.

At the same time the capital invested has grown from $4.4 billion to $8.5 billion. This figure is managed by funds which all vary in terms of their deal focus and investment orientation, as well as the quality of the manager and the investments.

Specialist fund advisers in the private equity market identify the following issues as being important in determining the quality of managers.

Consistency, track record and stability of senior management: This is important in an industry with long term time horizons and senior management must be committed to the business for the life of the fund.

Sectoral focus: Many funds will focus on industry niches and the expertise and experience in a sector of the management team where there is a good deal flow and attractive industry characteristics may be a significant advantage.

Access to good quality deals: In an increasingly competitive private equity market, a good deal flow in an industry where typically two to three per cent of investment opportunities reviewed are completed, is critical.

Appropriate fee structures: Management fees are typically in the range of two per cent on funds committed with an incentive fee based on performance.

In the last two years there have been several private equity funds offering the opportunity for retail investment. One of these, the Macquarie Private Equity Trust raised $85m from 2,300 retail investors in 1999.

The JB Were Private Equity Fund closed late last year with a heavily oversubscribed retail offering of $145m, from a minimum investment base of $30,000.

The success of these funds issues proves the growing appetite for private equity exposure. However the sustainability of this interest will depend on the performance of the funds as investors head into uncertain economic times.

Michael Traill is an Executive Director and co-founder in 1989 of Macquarie Direct Investment, the private equity arm of Macquarie Bank.