THE CASE FOR
Private equity investment in Europe is growing in popularity and stature among plan sponsors.
It could find a home in the portfolios of many Canadian pension plans.
By Paul Easterbrook
Private equity, as an investment for the general public and hold, due to the large number of business professionals edu-
especially the plan sponsor community, has come a long cated in U.S. business schools during that period.
way in the past decade. Whether it is here at home or in
the European market, investing in private equity is taking THE BASICS
shape as part of a new long-term strategy. So clearly there’s interest, but what accounts for private equi-
The growth of the asset class shows that many pen- ty’s rapid growth over the past 10 years? Before addressing
sion plans already have accepted private equity. Invest- that issue, it is important to take a step back and go over the
ments in private equity have increased rapidly over the basics. Private equity is a generic term for investments in pri-
last 10 years, with annual global commitments increas- vate companies (or public companies where the investment
ing to US$68 billion in 2002 from US$18 billion in has the character of a private equity transaction). The term
1990 and peaking at US$205 billion in 2000. “private equity” can broadly be broken down into the follow-
A recent report on alternative investing
issued by Goldman Sachs Global
Research and Russell Investment Group
(Tacoma, U.S.A.) indicates that pension
Europe vs. the U.S.: private equity returns
The investment horizon pooled net internal rate of return (IRR) for buyout funds.
plan sponsors around the world have
increased their allocation to private equity
over the past two years. In 2003, North 20.0
American institutions reported an average Europe
allocation to private equity of 7.5% of 15.0
total plan assets, and forecast that their 14.1
average allocation in 2005 will be 8.1%. 12.4
Plan sponsors are attracted to Euro-
pean private equity because of the 7.0
dynamic environment in Europe for a
variety of reasons:
1. Growth in the capital markets in
2. The advent of the euro,
3. Success and expansion of the Euro-
pean Union. (10.0)
20-Year 10-Year 5-Year 3-Year
Also, the concept of shareholder value
Horizon Source: Venture Economics, August 2003
that swept the U.S. in the 1990s is taking
www.benefitscanada.com NOVEMBER 2004 87
ing categories: venture capital, develop-
ment capital, and buy-outs/buy-ins. Private equity investments by country
Venture capital is often used to Investment in Europe increased from 10 billion euros in 1997 to 28 billion euros in 2002.
describe the private equity sector as a
whole, but more accurately describes
investments made at an early stage in a
Italy 10% Other 4%
company’s life. Scandinavia 9%
Development capital is financing
provided for the growth or expansion of Spain 4%
a company that is breaking even or trad-
Buy-outs/buy-ins refer to different
methods in private equity which are
applied to established businesses with
revenue and profit streams. Private equi-
ty managers provide funds to allow
management to acquire an existing busi-
ness or to enable managers from outside U.K. 37%
a company to buy into the company.
So why all the recent attention? The Source: EVCA
increased interest in private equity can be
attributed to the two major benefits the
asset class offers when added to a portfolio of stocks and return (IRR) for top quartile private equity funds formed
bonds. The first benefit is the potential to enhance returns. from 1980 to 2002 was 12.4%, while the cumulative net
Historically, private equity firms have generated returns IRR for lower quartile private equity funds formed in the
that outperform comparable publicly traded securities over same period was -5.6%. Spreads in North America are sim-
the medium to long term. A second benefit is private equi- ilarly distributed. That makes fund selection critically
ty improves diversification, given its historically low corre- important to successful investing in the asset class.
lation with the major public indices. The typical investment minimum in private equity funds
As with other asset classes, a bit of a disclaimer is need- is five million euros, with many of the top performing man-
ed. Investing in private equity comes with several issues agers asking for commitments in excess of this amount.
that need to be understood before any investment is Investors with limited amounts of capital to commit may
made. This is even more true of European private equity. find it difficult to adequately diversify their portfolio.
There are, however, some major issues when thinking As a result, as with other asset classes, diversification is a
about an investment in private equity. key feature in reducing overall risk within a portfolio. Pri-
For example, private equity funds, and particularly pri- vate equity funds often invest in a particular industry, sec-
vate equity funds in Europe, can be difficult for North tor or region and will generally have a limited number of
American investors to access. Some smaller, country-specif- underlying investments.
ic funds may be relatively unknown outside Europe and
tend to have small, closed investor bases. Larger funds can THE FUND-OF-FUNDS SOLUTION
be oversubscribed or require substantial minimum com- Investors participate in private equity deals by either
mitments. As a result, knowledge of local markets and per- investing directly in operating companies, in limited part-
sonal contacts are important for gaining access to funds. nerships that invest in operating companies, or in a fund
Also, the ability to evaluate a prospective fund requires of funds. A fund of funds invests in several private equity
considerable expertise and experience. The due diligence funds, rather than investing directly in operating compa-
process requires an extensive interviewing and reference- nies and can provide a number of benefits, while address-
gathering process, often in multiple languages. The strate- ing most of the issues raised above.
gy, personnel and motivation of a manager may change For example, private equity investments are time and
over time. Maintaining a dedicated, on-the-ground team labour intensive in terms of due diligence, investment,
in Europe is critical to the due-diligence process. legal review and monitoring. A fund of funds handles
In terms of returns, the spread from upper-quartile to each of these responsibilities, saving the costs of perform-
lower-quartile performance, for all stages of private equity ing the functions in-house.
investment, is more pronounced than in other asset classes. Also, a fund of funds that has an experienced advisor
For example, in Europe, the cumulative net internal rate of should get investors access to top performing funds,
www.benefitscanada.com NOVEMBER 2004 89
including those that usually accept investments only from has risen to 12% in 2003 from 0.5% in 1993. Moreover,
larger institutions, or those that are generally oversubscribed. continental Europe has seen greater private equity growth
It can also diversify across fund managers, industries, markets than the United Kingdom, the leader in European private
and investment strategies, thereby reducing risk. equity investment. In the mid-1990s, approximately half
Finally, a fund of funds offers participation in the asset of the private equity invested in Europe was invested in
class at a lower minimum commitment than by investing the U.K. From the mid-1990s onward, while the absolute
directly in private equity funds. level of private capital invested in the U.K. has remained
constant, there has been a marked increase in the amount
INCREASING ACCEPTANCE of capital invested in other countries.
An investment in a European private equity fund of funds The European Union, while not new, is presently
offers pension funds an opportunity because, as in North undergoing significant change and development that will
America, European private equity has demonstrated superior have a profound effect on the region for many years.
returns over public equities, as well as offering diversification There are presently 25 member nations in the EU (10
benefits. More notably and perhaps unexpectedly, European countries recently joined), and several others are expected
private equity funds have historically outperformed those of to follow within a few years, raising the aggregate popula-
the United States due to a relatively uncompetitive and inef- tion to a forecasted 500 million by 2007.
ficient market and the opportunity for excellent returns. Overall, there are numerous features of the EU that will
There are several reasons why European private equity benefit private equity investors in Europe, but one of the
should continue to generate attractive returns over the most significant is increased competition due to pricing
next five to 10 years. These include such things as a rela- transparencies, which should encourage the divestiture of
tively underdeveloped private equity market, and the non-core businesses. Also, there are fewer impediments for
increasing acceptance of private equity by society in gen- citizens who work and travel within the EU, which should
eral, both by investors and sellers of businesses. improve the supply of labour. Restrictions and taxes on trade
Private equity has become an accepted form of financ- among EU countries are relatively non-existent, and finally,
ing in Europe. As a proportion of total M&A activity, it there are stable economic environments in EU countries.
NEW TRENDS firms can help solve this problem by providing tempo-
There are several trends among corporations in Europe that rary resources or being better able to help select a senior
could have significant effects on M&A activities over the executive to fill the vacancy.
next several years. Similar to the trend over the past 25 years Another trend is consolidation in highly fragmented
in the U.S., European corporations are about to restructure industries. When compared to industries in the U.S.,
and refocus their operations on their core competencies. European industries tend to be significantly more frag-
Restructuring has been slower to happen in Europe mented and could be better positioned to benefit from
(almost 50% of companies are still diversified) but European consolidation. This can be shown by the greater number
corporations are now facing opportunities and challenges of large corporations in the U.S.: 1.5% of U.S. firms have
due to the new environment created by open borders and 500 or more employees, whereas European totals are sig-
transparent pricing of the EU. This should increase activity nificantly less (0.7% for Britain, 0.4% for France, 0.2%
in the M&A market, which, in turn, should provide invest- for Spain and 0.1% for Italy).
ment and divestiture opportunities for private equity firms. To conclude, it should be noted that private equity
The majority of businesses in Europe are family owned. returns are best during periods of change because of the
Some of these businesses are expected to transition over the product’s opportunistic nature and ability to react quick-
next 10 years due to the lack of family continuity. Private ly. Private equity also does well in inefficient markets such
equity plays an important role in these corporate transi- as Europe. Finally, private equity is a long-term asset class
tions for several reasons. First, the natural strategic acquir- which can offer liquidity, coupled with explosive growth
ers are the competitors and for reasons of pride, family potential, using the right structure. For that reason, Euro-
owners are averse to selling their businesses to their compe- pean private equity could find a home in many Canadian
tition. Private equity is recognized as a neutral party that pension fund portfolios. BC
can solve this delicate problem.
Second, the selling family member likely occupies a Paul Easterbrook is managing director and senior vice-president,
significant management position for which there may Schroder Investment Management North America Ltd. in Toronto.
not be an obvious replacement. Again, private equity Paul.Easterbrook@ca.schroders.com