The ripples of the sub-prime crisis have touched private equity, but there are still opportunities to be had. Andrew Sheen reports
John Gripton, a managing director and European head of investment at Capital Dynamics, said the main effect seen so far had been the reduction of leverage in transactions, which will lead to lower returns - although he stressed the fact private equity still had the potential to deliver higher returns than the public markets.
On a cap-by-cap basis, it seems clear the credit crunch has placed significant barriers to deals over US$1bn, but has had little effect on transactions in the small and mid cap area. Some observers have remarked that the sub-prime crisis has not caused a collapse of the private equity market so much as a 'correction'.
Gripton stated: "There inevitably had to be a correction, and we think it's now coming through, triggered by the sub-prime problems. But it was going to happen at some point anyway.
"Covenants are tighter than six months ago, but agreements look more like those from two or three years ago."
Sam Robinson, director of private equity fund management business, SVG Advisers, said prices had been at an all time high over the past few years. Managers had assumed this was unsustainable and thought they would sell for a lower multiple than they bought for. To compensate, the better managers had made more of an effort to add value to their businesses through restructuring.
Robinson said: "Managers are relieved that this Sword of Damocles has finally fallen. "It's not exactly business as usual, but I expect we'll be back up to relatively normal within the next few months."
Jane Welsh, senior investment consultant at Watson Wyatt, said the kinds of returns seen in the recent past were not likely to be repeated and it would likely force private equity back to its roots - the restructuring of businesses to perform better.
The California Public Employees Retirement System (CalPERS) has been a long-time exponent of the advantages of private equity. Since its alternative investment programme began in 1990, CalPERS has increased its allocation to private equity from 2% of its assets to 7.1% today, representing more than $17bn of ongoing investments. Over that time, the pension system said it had invested over $50bn in 5,000 companies and had returned more than $12bn profit.
CalPERS seemed largely unconcerned by the credit crunch, with a spokesperson for the scheme stating it had "a long history with some established private equity firms that have demonstrated their ability to ride out market storms".
The spokesperson also said that due to its size and financial muscle, CalPERS had the resources to take advantage of credit-constrained market opportunities.
Light at the end of the tunnel
Despite the setbacks caused by the economic environment, private equity remains an attractive proposition for many institutional investors.
Jeff Ennis, managing director and chief investment officer of Wilshire Private Markets, an investment management unit of Wilshire Associates, said private equity had become an integral part of many western economies and a mainstream asset class "in so far as a high percentage of institutional investors participate in it".
He said that about three quarters of all pension funds had some degree of exposure to private equity in their investment portfolios.
For Watson Wyatt's Welsh, the only reason to invest in the asset class is for the superior returns that are possible.
As she put it: "There's no other reason. There may be a little bit of diversification but the benefits [of that] are limited."
Welsh said superior returns could be generated by this asset class because private ownership of businesses - as opposed to being a shareholder in publicly traded equities - conferred certain advantages.
"You don't have to worry about quarterly earnings; you can take a long term view. You can align shareholder and management interests much more directly."
Gripton expanded on this point, saying there was lots of evidence to show private equity takeovers had a positive effect on a company's performance: "You can grow the business and leave a much stronger company."
However, Gripton made the point that returns depended very much on the manager.
He said: "The returns from PE through various periods and cycles have outperformed public markets. It's produced good returns - about 2% to 4% over and above the public markets.
"But returns can be very diverse - unlike the narrow band between the better and poorer performers on the public equity markets, there's a huge differential between the top and bottom performing managers."
Another much cited drawback to private equity is the high fees paid to managers. Welsh said investors often had little scope for negotiation, as really good managers were in short supply. She also said that due to the complexity of these investments, investors (particularly smaller pension funds) often needed more legal and tax advice and there was more administration to deal with.
Gripton said: "Many smaller pension funds don't have sufficient human resources or in-house expertise so they often outsource - usually through a fund of funds."
Private equity is also an illiquid asset, and investors have to be willing to put their money to work over a long period. Lock-up periods for private equity are often as long as ten years - which can pose a significant barrier to entry for some investors, but should be ideally suited to the long term outlook of pension funds.
As Robinson asked rhetorically: "If you can live with the illiquidity, why forego the extra returns?"
Welsh added that a secondary market for trading was evolving - albeit slowly - but pension funds should still consider private equity as primarily a long term asset class.
Robinson furthered this point of view, saying that every pension fund had funds it could afford to 'lock away' for ten to 15 years and that private equity was eminently suitable for this.
Despite the drawbacks, there are certain investment opportunities where private equity is clearly the only access route, such as early stage venture capital (VC), buyouts and the purchase of distressed corporate assets.
Russell Read, chief investment officer of CalPERS, said: "Our PE fund mangers invest across the spectrum of a company's lifecycle - from its early stage, growth and to maturity."
CalPERS was keen to stress it was actively investing in 'green' and socially responsible companies - including alternative energy start-ups, environmentally sound building companies and 'green' agriculture. As Reed commented, the inherent difficulty with such untested venture capital investments was that the associated risks were higher - it's impossible at such an early stage to tell which companies will be successful or unsuccessful.
Watson Wyatt's Welsh agreed: "An allocation to VC makes sense - but there's a risk-reward trade-off. There may be one fantastic winner in the portfolio, but some of the investments may go to nothing."
Over the very long term, she said, VC had generated some very high returns for the extra risk, but she warned access to the best venture capital groups could be difficult, so suggested a fund of fund route may be the best way to go about it.
Wilshire's Ennis said venture capital had largely recovered from the downturn it experienced following the dotcom crash in the early 1990s. He said there had been a few notable IPOs in the region of US$1bn or more, which made the sector more attractive.
The most obvious VC success story of the past ten years has, of course, been Google. The initial round of venture capital investment funded the company with $25m, only to see its market value grow to almost $200bn with a share price that has regularly traded in excess of $600.
But Ennis cautioned: "Managers have no control over the economic environment when they come to exit and that can impact on the holding period."
Welsh agreed it was difficult to time a private equity investment, especially when pursued through a fund of fund strategy: "If you commit to a direct fund today, it might be three or more years before that money is invested in a company through a fund of funds. You can't predict the business environment that far."
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