Investment Panel (April 2007) - What price will be paid?

Chairman
Jane Welsh
Senior investment consultant
Watson Wyatt
Welsh is an investment consultant at Watson Wyatt and focuses on manager research where she has responsibility for global equity, private equity and absolute return managers.

Richard Graham,
Head of institutional business,
Baring Asset Management
Graham is head of Institutional Business, which includes responsibility for LDI solutions for UK pension funds.

Nina Harris
Institutional Relationship Manager
Morley Fund Management
Harris joined Morley in March 2006 as institutional relationship manager to promote the firm’s investment expertise to UK corporate pension schemes and their investment consultants.

George Walker
Head of UK institutional business
Standard Life Investments
Walker is responsible for overseeing the UK business and for Standard Life Investments’ asset class product specialists. He joined Standard Life Investments in 2001 after more than ten years at Friends Ivory & Sime.


Welsh: Are private equity/infrastructure returns being jeopardised by the prices being paid for assets and the amount of leverage being used?

GRAHAM: It is clear to see from the rising share prices of many smaller companies, fuelled by whispers of mergers and buyouts, that private equity is currently over-priced. A reasonable proxy for demonstrating this would be to compare the price earnings ratio of European small-cap companies to their large-cap rivals, and currently European smaller companies are more expensive by nearly 30pc.
At same time, we don’t believe that the historic returns or the low volatility in private equity are sustainable, or credible for future expected return characteristics. Many people cite Yale, a large US university endowment fund, as an institution that has managed to make exceptional returns from its private equity exposure, but the reasons for this are more to do with the fact that they “bought in” when the market had fewer players, and because they themselves had a private equity team with the expertise to research and pick the best managers. Pension funds in the UK are typically not as well-endowed in assets nor have teams of analysts specialising in private equity compared to their US counterparts.
Investment in private equity now is at risk of following a momentum trade – look at the amounts involved taking public companies private – which we think likely to unwind.

HARRIS: The price paid for an asset is not the only variable in determining the returns that can be achieved. Intrinsically, higher prices being paid would normally lead to lower returns, but there are many other factors and skill sets, an example being operational improvements, that can be employed to enable the historic level of returns to be maintained. In addition, opportunities in the market are expected to increase, which will in part offset the competition that can lead to higher prices being paid.

WALKER: Our private equity team do not invest in infrastructure funds. However, from a private equity perspective the price paid for a private equity asset – for example, a management buy out – is determined by the return that a private equity manager believes he can achieve over the holding period, and this is driven by the strategy for the investment during that time.
Our private equity team see no evidence to suggest that leading private equity managers are reducing their return expectations. The team track the prices paid and the amount of leverage used in transactions. Neither the prices nor the leverage are exceptionally high, compared with the levels seen in previous cycles. What is different is that debt is significantly cheaper than in previous cycles and other terms are also more favourable, for example, the amortisation of capital and the covenants.
A less favourable change is that companies have encountered difficult trading conditions when trading in the debt of large buyouts. Traditionally, in Europe the banks that provided the debt took the asset on their own balance sheet, but today they retain very little and sell it on to various holders such as hedge funds. This will make it much more difficult to restructure a debt facility if a company is in difficulty and expose the company and its private equity backers to distressed debt investors.
The best private equity managers continue to exercise discipline in the price they will pay and also the amount of leverage they accept, often investing more equity instead of taking the maximum debt available. It is worth noting that our proviste equity team’s analysis shows that the managers they back achieve about 65pc of the return from their investments through improvements in operating profits of the businesses they buy, not from simply buying cheap and using leverage. Investment returns at this point in the cycle are, as expected, very good and generally above expectations.
As this cycle develops, our private equity team would expect investment returns to moderate to more normal levels, which would still be highly attractive compared with other asset classes. They believe that key to successful investment in private equity is gaining access to the best managers which require established relationships; indeed many of the leading managers are closed to new investors. Standard Life Investments’ private equity firm has achieved access due to its long standing relationships with leading managers and because we are a sought after investor.


WELSH: How can infrastructure managers justify their fees (which are similar to private equity) when expected returns are so much lower than for private equity?

GRAHAM: Infrastructure investment is generally less volatile and returns are more predictable than traditional private equity. In many ways, infrastructure behaves more like emerging market bonds with higher yields but some significant capital risk. Demand also remains high for infrastructure projects, particularly within the emerging market world, but the number of investment vehicles out there offering access to these projects is small, as a result fees are high. Also, the lock in period doesn’t always need to be as long as traditional private equity.
However, where there are long lock ins, political threats to projects, and insufficient convergence of interest between the government (representing the consumer) and the infrastructure provider (representing the investors) then neither the risk premium or high fees is justified.

HARRIS: Some infrastructure funds have achieved higher returns than private equity funds, but on average they are lower. Infrastructure managers usually state their target level of return and these are often lower than private equity returns, but they might say that they are seeking returns greater than for some other asset classes and that they are part of a diversified portfolio of assets. If net returns of infrastructure funds are higher than those achieved in other asset classes, it can arguably be worth investing. In addition to higher returns, investors are paying higher fees for access to top construction companies and other opportunities that infrastructure funds can present. However, remember it is up to each individual investor to assess their risk versus reward profile.

WALKER: Our private equity team do not invest in infrastructure funds and therefore we cannot comment. However, this same point may be levelled at hedge funds, which also have similar fees and potentially lower returns.


Welsh: Will the recent announcements of listings for private equity groups be the start of a trend and what implications does it have for the industry?

GRAHAM: Private equity investment trusts, otherwise known as PEITs, have been around for years, but they have recently attracted more interest essentially because private equity firms realise the potential PEITs have for continuously raising funds and offering a way into private equity for investors that do not have the cashflow required for limited partnership investing, or the governance to justify direct entry.
Listed ‘alternatives’ can also be much easier on institutional and high-net-worth investors’ portfolios, largely because they provide liquidity and no lock-ins. The investment is bought and sold on an exchange, whereas disposing of direct private equity investments requires selling the ‘investment’ on the secondary market, which may take months of negotiating before a buyer is found.
The downside with PEITs, however, is that the diversification argument can be weakened because the correlation with listed equities is likely to increase. This is mostly because the investment trust is more exposed to market sentiment, as opposed to the performance of the underlying investment holdings – which a direct private equity holding would be.

HARRIS: Listed private equity vehicles have been in existence for a very long time so it is not a new phenomenon. However, over the past few years some new groups have listed and hence there is the perception of a trend. It should be noted that the vast majority of private equity groups are too small to list and it is only a few large groups for whom it might be suitable. One of the reasons cited is that listing provides a permanent source of capital which means the private equity groups do not have to go to market every four to five years to raise new funds and this enables them to focus on investing rather than fund raising.
In terms of implications this will have on the industry, we are not expecting everyone to list, there is still a place for both strategies. Listing has, however, opened up new avenues for investment for alternatives investors, giving access where it has not been available before, particularly at the high net-worth, retail end of the market.

WALKER: Standard Life’s European private equity trust is a private equity vehicle that was listed in 2001 and is one of, if not the best performing private equity investment trusts in the marketplace. There are likely to be more listed private equity vehicles in future because they provide managers with permanent capital, they open up private equity investment firstly to institutions that cannot invest in the usual partnership structure and to retail investors and they also provide a hedge against the long term decline in defined benefit pension funds as a source of capital to invest. Listed private equity vehicles also provide the partners of the very largest of private equity groups with an opportunity to valorise their personal holding in the firm, especially as the senior partners approach retirement. The very largest private equity groups are latter day equivalents of JP Morgan and Goldman Sachs, offering a range of product offerings in alternative assets. It is hardly surprising that these large organisations will seek to become listed on public markets.