Why is Private Equity on the Rise?
Awareness of private equity amongst investors has grown significantly in recent years. For example, the number of mentions of ‘private equity’ in the Australian Financial Review has increased by over 54 per cent per annum in the past 10 years. But what exactly is private equity and what does it mean for sophisticated investors?
Private equity funds generally invest equity (rather than debt) into private (rather than public) companies. Private equity is an important asset class that can provide strong returns and diversification benefits to an investment portfolio.
A recent KPMG/Deakin University study showed that 30 per cent of business owners plan to retire within the next five years although 68% have not chosen a successor. Private equity can provide a solution by helping management to acquire businesses from founders looking to retire. This process is often known as a management buyout (MBO). With renewed capital structures, private equity can then help businesses to grow organically or by acquisition. Recent examples include ACL and Netti.
Other targets for private equity investments include non-core divestments (such as Accantia/Swisspers and John West); ‘undervalued’ public companies (such as Just Jeans and potentially Coles); and earlier stage venture investing to fund growth (such as Comtech or Seek).
Private equity funds respond to these business demands. Firms usually raise funds from high net worth individuals and superannuation funds through long-term funds. Investors expect private equity to provide premium equity returns and add diversification to their portfolios.
What sort of companies do Private Equity Firms Buy?
Private equity firms’ investment criteria vary. However, most private equity firms look primarily for a team of proven, honest managers that have established a good record operating the actual (or similar) business and can align their interests with investors.
Strong business cash flows will often lead to a more leveraged capital structure. Substantial growth potential, a reasonable entry price and future exit prospects are all important factors. Good private equity firms will also only select companies where both they and the management team agree that the private equity firm can provide strategic and financial assistance and counsel to deliver on its strategy. This is difficult to measure and often comes down to the fit between the personalities.
How do Companies sell to Private Equity Firms?
Engaging an advisor to run a sales process involves inviting several trade buyers and financial investors to tender their interest. While such competitive tension can maximise the likely price, it may also risk sensitive information falling into competitors’ hands. If not run correctly, this may tarnish the business, particularly in the case of an aborted sale.
Alternatively, vendors may enable a private equity firm to have a preliminary look at the business. If they can meet the vendor’s price expectations, then they together enter into exclusive arrangements to complete more detailed due diligence and documentation.
There are several advantages of a vendor approaching a private equity firm (in partnership with management) in the first instance particularly where the following factors are important:
- Management’s understanding of the business may require less due diligence than outside parties;
- The confidential process minimises the chance of damaging information leaks;
- There is flexibility to move later to an auction sales process if private equity does not proceed;
- They may wish to reward loyal staff (common in private businesses); and
- MBOs can often be more acceptable to other stakeholders including competition regulators, the broader workforce, customers and suppliers.
What are the Potential Returns and Some Risks?
Premium returns can result from the extra risk compared to listed companies driven by factors such as:
- Size - generally smaller businesses
- Financial – often more leveraged
- Liquidity - there is no public market to sell the investment instantly
- Inefficiency - the information asymmetry in private markets as to buyers and sellers often leads to more attractive entry prices.
Private equity firms also seek to better align the interests of the managers and owners as both are investors in the business.
Indeed, while the data is imperfect, private equity firms have generally outperformed the public equity indices over the long term. Most firms seek to achieve greater than 15-25 per cent annual returns to investors versus the approximately 10% long-term average of public equity markets.
However the dispersion around the mean can be quite significant with a Cambridge study showing 9 per cent per annum difference between the top quartile and median private equity fund manager in the US (versus a less than 3 per cent per annum difference between top quartile and medium public equity or fixed income managers).
Australian institutional investors have lifted their private equity allocations to 6.9 per cent according to the 2006-07 Russell Survey on Alternative Investing. This is still below the US average and almost one-third of the US Ivy League endowments such as Yale. Alternative investments such as absolute return and private equity tend to account for approximately half of the leading US endowment fund’s allocations. This is in stark contrast to Australian superannuation funds that average 24.5 per cent of their portfolio in fixed income and cash (according to the Association of Superannuation Funds of Australia and the Australian Prudential Regulation Authority).
Investors including institutions and financial planner-advised clients have increased their private equity allocation in response to their rising expectations of returns from private equity portfolios. Both US and Australian investors now expect 12 per cent per annum returns from their private equity portfolios. This has led to 73 per cent of Australian institutional investors now investing in private equity funds versus 64 per cent in 2001 (according to Russell). The data on high-net-worth individuals committing to private equity funds is incomplete but the anecdotal evidence is that this has also grown significantly.
However, these overall statistics do not take into account the liability and spending requirements of individual funds and portfolios. This is clearly an important financial planning consideration given the relative illiquidity and J-curve of private equity investing. Planners need to consider the risk profile of each investor, particularly with regard to their risk and liquidity appetite versus desire for supercharged returns.
For example, a material private equity allocation is generally not appropriate for individuals that are focused purely on capital preservation and have a short term horizon for their investments. Indeed the average private equity fund has a 10-year life. It calls capital as required to make investments during the first five years and then returns capital whenever it receives a distribution or sells a business.
Thus while funds may start returning capital after approximately three years, this is still quite a different proposition to a traditional public equities portfolio in terms of liquidity and time horizon. This is one reason why university endowments and very wealthy families with a long term horizon are often well suited to having a large allocation to private equity. They trade liquidity off against long term returns and extra diversification.
How does the Market Segment and Is Bigger Better?
The Australian market is segmenting fast. This segmentation is predominantly defined by fund size. The average fund seeks to invest in 8-12 investments per fund in a diverse set of industries. Thus larger funds generally want to invest more equity per deal thereby focusing on larger companies.
Firms that previously invested successfully in the smaller mid-market have raised larger funds – with a 27 per cent compound annual growth rate (CAGR) in the average fund size from 1999 - 2006 and 63 per cent CAGR from 2003-2006 according to a recent AVCAL/PricewaterhouseCoopers study.
Until 2003, the average Australian private equity fund had less than $100 million under management. It is within this context that the Reserve Bank of Australia reports that the average enterprise value (equity plus net debt) of Australian private equity deals has grown from less than $100 million prior to 2005 to almost $1 billion in 2006.
Today, very few Australian funds are of a size and scale that enables them to focus on the small-medium enterprises (SMEs). Yet SMEs facing succession issues have traditionally fuelled the demand (and returns) for the local industry. The move to larger fund sizes means that firms need to focus on larger, higher profile transactions such as Coles and PBL where they often compete with a range of trade buyers, international funds and the complexities of public-to-privates (P2Ps).
As a result, we are seeing the market bifurcate into large funds and the traditional SME focused funds. Investors often look for a diverse portfolio and seek to pick and access the top quartile performers in each market segment with diversification across fund vintages and fund managers.
How are Private Equity Firms Incentivised to Perform for Investors?
Private equity firms’ fee structures emphasise alignment of interests. Most private equity firms earn a 2 per cent per annum management fee to cover their operating costs. The principals’ performance ‘bonus’ is from achieving strong capital gains in the portfolio. They typically receive 20 per cent of the profits after returning the capital through a carried interest reward.
This model has traditionally worked well. However, there is some pushback against the 2 per cent fee still applying to very large multi-billion dollar funds. Ultimately the market decides and if these funds perform then they continue to receive capital on these terms. For those that outperform or have smaller funds, sometimes the fee structure is higher than the traditional 2 per cent /20 per cent structure.
How Can Financial Planners Access Private Equity?
It can be difficult for investors to access private equity funds.
Australian private equity firms used to be owned predominantly by financial institutions that marketed funds through traditional distribution channels. However, the industry has moved away from these ‘captive’ funds due to investor concerns about the conflicts of interest in larger organisations and by investment professionals’ desires to be owners in their owned focused firms.
These newer boutique firms generally keep a very low profile, with nominal external marketing and a limited number of wholesale investors– predominantly institutions and high-net-worth families. Many will not accept retail subscriptions.
High net worth individuals can access private equity in three main ways.
First they can develop their own programs and invest directly into a portfolio of private companies. This is very rare in Australia, although happens by exception particularly in Asia and Europe when families hire professional private equity teams.
Secondly, investors and their advisors can approach specific private equity funds during their fund raising cycle (generally every 3-4 years) and seek access. They usually need to be a sophisticated investor depending upon the funds’ Australian Financial Services License (AFSL).
Thirdly, they can access private equity through a fund of funds approach. Financial planners with the appropriate AFSL have started to move into this fund of funds area. There are also some dedicated boutique fund of fund managers.
No path is perfect and indeed private equity may not suit many investors. Gaining quality assistance from financial planners that understand the overall investor’s needs and portfolio can be critical to ensure appropriate investment choices.
Final reflections
Private equity is here to stay. It serves an important link in the economy, particularly for business owners looking to sell and for investors looking for higher returns and some diversification in their portfolio but mindful of the risks and illiquidity. Financial planners are recognising this opportunity and can add tremendous value to their clients by enabling access where appropriate for their high net worth clients to place an allocation with the most suitable private equity funds.
About the Author and Disclaimer
Jeremy A. Samuel is the Managing Director of Anacacia Capital – a boutique private equity fund manager that invests alongside proven management teams in established small-medium enterprises. This article is not a substitute for independent advice and does not necessarily represent the, opinion or advice of the author or his employer. Readers can contact the author at jeremysamuel@anacacia.com.au.
© Financial Planning 2007