Irish Association of Investment Managers
Series of articles on Investments
Alternative Investments Part 1 - Private Equity The challenge of maximising real returns in a low inflation, low interest rate environment is encouraging investors to re-examine their portfolios. Private equity has attracted the attention of many investors since it has the potential to offer attractive rates of return while also being a genuine diversification away from the listed equity markets. Private equity is a broad term for any equity type investment in a company that is not listed on a stock exchange. Expected Returns Private equity offers the opportunity to share in the development of companies that have the potential to achieve above average growth. This means rates of return are typically superior to investments in listed companies, which tend to be at a more mature stage in their development. Managers of private equity investments work in partnership with the firms they invest in to create value by growing the revenues and profits of their businesses. Private equity managers are effectively the ultimate ‘growth stock pickers’ since funds hold large, usually controlling stakes in companies. Ultimately, it is the collaboration of management and private equity managers that control a company’s destiny, and not the vagaries of the stock market. The European Venture Capital Association reports that over the last ten years, the average buy-out managers in Europe have produced internal rates of return of over 17% (December 2002). However, the top quartile managers have generated returns of almost 33% over the same period, illustrating the crucial importance of selecting the best managers. Risk Many investors perceive private equity as high risk. This stems from its association with venture capital, which is a riskier sub-sector of the asset class. However, investing in a start-up company is just one aspect of private equity. By far the largest part of the European private equity market involves buyouts of established companies with solid customer bases, proven products and quality management. A number of studies have shown that private equity returns are not closely related with returns from traditional asset classes. This means private equity can help to smooth out the return of a balanced portfolio. Studies by Standard Life Investments of 10 private equity funds invested in the UK in the 9 years to 2001 and FTSE All Share returns over the same time periods showed the average correlation to be 22%. Given that correlations between US and UK stock markets often exceed 80%, it is clear that investment in private equity can offer significant diversification benefits and actually lower the risk and volatility of a balanced portfolio.
Liquidity Private equity is still seen as highly illiquid. While this is true to an extent, liquidity in private equity can be compared with other commonly held assets. In property, for instance, transactions can take three to six months to complete and sizeable transaction costs make for a lack of liquidity, at least in the medium term. Even quoted companies are not necessarily liquid with trading volumes for small cap companies making it difficult to realise significant positions. While investment in private equity funds may be illiquid, there is a growing secondary market for investors seeking liquidity and this is likely to develop further in the years ahead. One way of achieving greater liquidity is for investors to purchase shares in an investment trust listed on the London Stock Exchange, such as the Standard Life European Private Equity Trust. In this way, investors can buy and sell the investment in the same way as any other share. Access and Charges The premier funds are often accessible only to investors able to make commitments of €10 million in each fund, so creating a diversified portfolio of around ten private equity funds would require a commitment of around €100 million. Instead, investors need to focus on getting diversified exposure to the best performing managers. For most investors, the most effective solution will be to use a fund of funds, a vehicle whose popularity has grown rapidly, particularly during the last five years. The wide variation in private equity returns between top quartile and median managers is the main driver for investors to use a fund of funds in order to get diversified exposure to the top performing funds.
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A fund of funds manager invests in a portfolio of private equity funds that allow diversification by country, industry, manager and investment stage. Funds of funds give access to substantial deal flow and remove the need for investors to devote time to the due diligence process and the negotiations involved in direct investment. Funds of funds sometimes come under fire for their higher fee structure, but for most investors the additional fees are more than outweighed by the outperformance of the
best performing fund of fund managers and also by the costs of developing the same expertise in-house.
Stewart Hay, Investment Director, Private Equities, Standard Life Investments. Standard Life is a member of the Retail committee of the Irish Association of Investment Managers.
Published 29th July 2004 – Irish Independent