Private equity investment (PE) is a substantial and growing area of the investment markets, arguably much in vogue and seen as a panacea for difficult and disappointing returns in liquid public markets. IAM have been directly involved in this area for over 40 years. Whilst considered a vital part of modern private client portfolio management it is in our view not properly understood and easily misrepresented. It must be approached with considerable caution. There are selective attractive opportunities, but it is, arguably, as a function of current popularity, over-priced and overleveraged in some areas. In such an environment risk control becomes critical, particularly in how any successful PE strategy interfaces with the rest of the marketable portfolio. PE requires a completely different of risk control than the conventional approach for liquid assets. We have set out below a high-level summary of our PE philosophy and are happy to go into more detail with clients seeking to add PE to their portfolios.
The IAM approach to a successful PE strategy
At the outset there needs to be a distinction between investment in private equity, as an asset class and a single ‘one off’ investment or a residual family holding in an illiquid position It is the asset class that is addressed in this article, it is important that this is done through a well-articulated strategy. This will encompass direct investments, through specialist funds, limited partnership, co-investment, investment trusts etc. Risk control is paramount and complex.
The total exposure to the asset class and how it is managed will depend on the character of the investments being considered and how this links with the liquid assets held elsewhere in the client’s portfolio. As a consequence it is impossible to be proscriptive on the size of the allocation. We have clients with leveraged liquid assets, that are themselves risky, with modest allocation of 5-10% and those with substantial allocations, in the so called endowment models, where average positions can exceed 40%.
As with any asset class, risk diversification is key, but the nature of this is different from conventional portfolio construction and the following elements need to be addressed in a PE mandate with appropriate restrictions,
The choice of manager for a fund or LP either for direct investment or through fund of funds is critical. Manager skill is important and varies over time and by type of strategy. For example, one manager might be excellent in distressed equity but poor in early-stage venture capital. GP management does not necessarily lend itself to handling multi-manager funds, and indeed are conflicted, whilst some managers excel in this area. Closed ended investment trusts develop a wide range of experience, across all entry points from direct investment, through specialist managers and all types of strategy they can access co-investment opportunities and manage complex cash flows.
Diversification geographically is important and surprisingly more relevant than in equity portfolios. It tends to be regional in character. Investment in the USA is completely different than in individual European countries or the Far East. Highly successful US managers often cannot ‘travel’ and can become badly unstuck in a different legal and regulatory environment. Some disciplines might be better approached internationally, allowing access to greater range of possibilities. Private equity cycles differ, one country/area to another.
Managers with non-reporting currency investment will generally tend to hedge these exposures. The preponderance of US dollar-based funds needs to be considered in terms of a client’s risk profile. The manager’s policy on currency needs to be determined and how of if this influences their regional exposure.
4. Vintage Year
There is a pronounced cyclicality to private equity investments. This has reduced in recent years and was disrupted by the Credit Crunch, with signs that this is also the case in the recent market downturn. There is a significant cyclical reaction to recession and this alters by strategy and, as mentioned, by geography. The timing of investment is important, remembering that a commitment now is not at present prices but over an investment period that might easily be over five years plus. Increasingly, managers are warehousing initial investment, which might appear attractive and brings investment forward but can distort performance figures and indeed concentrate investment at a time, which is not necessarily ideal. This increases risk, whilst cosmetically appearing attractive. With PE it is axiomatic that the historic record is most certainly not a useful projector of future returns by manager or type of strategy.
One needs to consider how best to approach the increasing number of different PE strategies. These could range from seed capital for new ventures through to mega billion leverage buyouts and complex debt programmes. Each strategy has a time and place. The range on offer is becoming increasingly specialist and niche, with the ever present danger of taking risks that would never normally be considered in liquid equity markets. At the other end of the scale, there are strategies that are tailored for major SWF and Pension funds that are not suitable for private clients even when ‘packaged’ to appeal.
6. Pipeline and Drawdown
Managers selected should have the ability to demonstrate a pipeline of deals and reflect this in regular drawdowns. We have seen long periods where funds have been established and made no investment either, because none were available, or criteria were set too high. Sometimes the managers continue to charge fees on committed capital. There are also concerns surrounding the transfer of investments between follow on funds to provide liquidity for older funds. Issues of transfer valuation become important and often problematic.
Clients have regularly over committed as a means to ensure the asset allocation is maintained and relying on distributions to finance new commitments. Such an approach needs to carefully managed and several large endowment funds came unstuck with over-commitment through the Credit Crunch.
Any successful PE programme will be diversified by all the above elements with a clear set of risk guidelines and a disciplined approach to how the programme is implemented within the mandate set.
Manager Fund Selection
The process of due diligence on a fund will depend on the type of PE investment being considered with responses to a detailed pro-forma questionnaire, an information file, manager’s presentation, meeting notes, etc.
Monitoring and Reporting
Once established, the process of monitoring and reporting on a PE programme is different from that of a liquid portfolio, which is based on continuous valuations and material in the public domain.
First, and self-evidently, one is committed to the investment so it is rarely possible to decide, on reflection, that you do want to participate, after a few poor results. There is generally an obligation to continue to fund the programme and failure to do so will mean losing the existing investments. You cannot alter outcomes or exit.
Second, valuations are also difficult and, whilst there are standard rules, they give no indication of the risks being taken and/or leverage to achieve these. The final return is after the last investment has been sold. This is why investment returns are difficult to analyse, with much controversy surrounding measures such as IRR and multiples, such as MOIC and TVPI. It certainly true that these should not be compared with liquid assets equivalents, as unfortunately is regularly the case.
Monitoring is important in terms of managing cashflow and getting indications as to likely distributions and how these match anticipated drawdowns both in the same fund and elsewhere in the PE strategy. This needs to be a product of regular interface with the manager.
It is also important to stay close to a manager to see how good they are in terms of service levels and beyond just good returns. As, is typically the case, where there are follow on funds the actual client experience of a manager is an important indicator of whether you follow-on.
Opportunities in PE
In my next post I will address the various types of structure in which an investor can access the private equity market and the current prospects for this asset class.