Time to dip your toe?

The uncertain outlook for public equities, coupled with the continued demand for strong returns, has forced many pension funds to look for alternative sources of growth, such as private equity.

Over the past 10 years, UK private equity funds have returned 16.4pc a year (net of fees), compared with 7.9pc a year produced by the FTSE-All Share Index and 8pc a year by the WM Pension Fund universe. Private equity investments have also grown considerably over the last decade, from £5.6bn in 1995 to £24.2bn in 2005 in the UK alone.

There is no doubt that the excellent past performance of the asset class is winning over many schemes, some of them venturing as far as handling private equity deals on their own.

In fact, UK pension funds doubled their direct investment into private equity last year. However, while some high-profile pension funds, such as Hermes, have made very large fresh commitments to direct investment, most pension funds would struggle to establish a direct private equity portfolio on their own.

Indeed, previous private equity cycles have shown that as well as offering significant opportunities, this asset class also comes with numerous hazards. Investing directly into private companies can prove particularly risky and, unless the pension fund is closely connected to a leading private equity manager, this would be an ill-advised route into the asset class.

Even establishing a fund of funds portfolio requires a team with experience and a proven ability to identify successful funds. This is particularly important for investors in the mid-market. A topnotch fund of funds team is also crucial for selecting emerging managers.

The rewards of successful investment in what are generally inefficient and under-researched areas can be excellent, but things can go badly wrong very quickly.

A mistake cannot be easily remedied by selling in the market and switching to another fund or direct investment, as they are when investing in public equity. In private equity, mistakes have a way of haunting you for years.

Proven Skills
Superior returns from private equity are achieved by applying specific labour-intensive skills and techniques.
Private equity funds exercise control over the companies in which they invest and can influence strategy and, if required, can bring in new management teams to make the company more profitable.

While private equity investment has much in common with investing in the stockmarket, holding periods typically last for years rather than months and involve direct insight into the inner workings of a company.

The end game in private equity is also a big part of achieving the return and again this is where the private equity investor applies their expertise to maximise price.

All of this added value does not come cheap and requires considerable resource, and, accordingly, private equity funds’ fees are typically higher than those for public equity but they are more than justified by their performance track record.

In a class of their own
From time to time, industry commentators have questioned the need for private equity investment. For example, it has been suggested that private equity-type returns could be achieved at lower cost through leveraging a portfolio of small cap-listed shares.

It is true that applying private equity techniques to public companies can enhance returns, but normally only by accepting higher risk than is usual for public companies. In particular, an investor in public companies, who wants the value enhancing advantages of an insider, will not have the advantage of liquidity which he could otherwise posses in a public equity market.

Whether a minority position in a public company will ever give the informational and other advantages, sufficient to compensate for the loss of liquidity, is highly questionable. What is certain is that this approach could not be applied successfully across the market as a whole without the involvement of an extraordinarily large fund and, therefore, a lot would to depend on the stock-picking abilities of the fund manager. In this scenario the risk/reward ratio would not look particularly attractive.

Levelling out risks by investing through a fund of private equity funds
Controlling risk is absolutely critical to private equity. Even when invested through funds, private equity can carry considerably higher risk than listed investments. This relates to the underlying companies which often have high gearing, are generally smaller than listed companies and can have more limited product ranges.

On average, in the private equity universe the risk of capital loss is higher in venture capital funds, which back very young companies in the earliest phases of their development where there is a lot of uncertainty about ultimate outcome, and lower in mezzanine capital funds, where the higher ranking in the capital structure provides better downside security.

Amid private equity funds as a whole there is usually a very wide spread between the best and the worst returns, which explains why increasing numbers of institutional investors favour the funds of funds approach to investing in the asset class.

Hamish Mair is head of private equity funds at F&C Asset Management