Written By: Matthew Craig
Private equity is perhaps the unsung hero of return-seeking assets in pension fund investment portfolios. Matthew Craig examines how local authorities can benefit from the private equity factor.
In recent years private equity has been overshadowed by more exotic or fashionable rivals, such as emerging markets, hedge funds and different varieties of fixed income, along with infrastructure and other real assets.
Investing in the rise of China and Brazil, or the need for new airports and railways, may provide colour and investment gravitas to a portfolio, but private equity managers who invest in real businesses and help them continue to grow, or turn them around, still have a good story to tell. And for those prepared to stick with it, private equity can be a rewarding asset which also gives some useful diversification benefits.
In theory, private equity is a more illiquid asset class than public (or listed) equities, but through this illiquidity, investors may obtain better returns. Is this really the case? Views on the existence of an “illiquidity premium” in private equity are mixed, and most investors and managers stress that investing with good, or top quartile, performers is vital. Morgan Stanley Alternative Investment Partners managing director, Neil Harper, said: “We have looked at data over a fairly long time period and it shows median private equity returns giving a modest premium over public equity, of say 2-4%. But the premise behind the question is true; there can be a real return premium achieved from accessing top quartile funds. We target a minimum return of 6% over public equity, partly to achieve an illiquidity premium, and partly to ensure that we continuously achieve top quartile returns.” So investors need to find the right managers to really benefit from an illiquidity premium.
However, Hymans Robertson partner and head of LGPS investment, Linda Selman, commented: “It is difficult to identify an illiquidity premium because of the complexity of private equity funds, which may use gearing, and managers may be quite aggressive in driving businesses that they invest in, in the short term. It is not clear that there are excess returns coming from illiquidity.” Against this, Merseyside Pension Fund has invested in private equity since 1981 and its head of investment, Peter Wallach, said he believed that private equity has an illiquidity premium. “If you are investing in private equity, you should expect a better return than if you are investing in public markets. We have been investing in private equity since 1981, so we have a 30-year track record and over that time, we have had an average return of 13.7% per annum from private equity. In comparison, WM data shows that equity markets gave an average return of 8.5% over the last 20 years, which suggests that there is an illiquidity premium. I would like to say that the difference is due to superior fund selection – and it is in part, but there is also an illiquidity premium and we are unable to split out the two.”
Wallach added that investing with good managers in private equity is an absolute given and here, having a longterm record of using private equity helps: “If you have access to the better performing funds, then when they raise new funds you can re-invest with them.” If this is the case, according to Wallach, investors can enjoy sustained performance. “The persistence of outperformance is also better with private equity than public equity. If you have access to good private equity managers and re-invest with them, it helps produce more success over the long term,” he commented.
While the numbers that private equity offers can look very alluring, AllenbridgeEpic senior adviser, John Jones, stressed that investors need to be prepared to commit to the asset class for as long as 10-15 years if they invest. Again, Jones said having a good manager is critical for investors. With these qualifications, private equity could be very suitable for local authority pension funds. “As far as local authority funds are concerned, since they are generally cash positive, private equity does offer opportunities to add value. Each pension fund should look at it based on its own position and time horizons, and decide for itself. Pension funds also need to be very clear about who is investing the money and what the managers are getting into.”
One effect of the global financial crisis of 2008 and the subsequentredrawing of the investment landscape, is that private equity has returned to its traditional roots and moved away from huge deals based on easy credit and clever financial engineering. Hymans’ Selman commented: “After the crisis, there have been a greater proportion of secondary funds being invested in by private equity managers. They were often able to buy at a discount because of distressed selling, and this has also given greater visibility on underlying investments, which has allowed managers to ensure that their portfolios are better diversified. Another feature is that some fund-of-funds managers are evaluating underlying managers differently. In particular, they are seeking to understand which private equity managers can really manage the assets, and which use leverage to boost their returns.” Merseyside’s Wallach agreed that there have been changes in the last few years: “In 2008, we started to de-emphasise the very large funds, when highly-leveraged buyouts by mega-cap funds became more challenging, we were moving towards small- and mid-cap funds in the UK, which is an area where we feel we can add value and so invest directly. We use fund of funds in other areas, such as for the US and Europe. We like the small- and mid-cap sector, where managers are reliant on the traditional private equity skills of providing management, operational controls, sales and marketing and financial disciplines better, rather than relying on high levels of gearing and financial engineering to get returns. There is still a place for large buyouts which are less reliant on financial engineering and more on the other skills.”
When local authority pension funds and others invest in private equity, it is generally wise to diversify investment, in order to get a good spread of underlying assets. As well as getting exposure to different private equity managers, investors are likely to want to diversify by region or country and also by vintage, or the year in which funds are committed to a private equity fund. Selman commented: “In our experience, most pension funds adopt a fund-of-funds route, so that they get diversification. Initially, £10 million can get an investor started and this much may be invested for a couple of years running.” In terms of diversification, Wallach commented: “Typically we invest £10 million+ per private equity fund and in six to eight funds per annum in order to get adequate diversification. We diversify by sector as well as by vintage and geography; large buyout, mid-market, venture capital, secondary funds and fund of funds.”
Typically, a commitment is made in a given year and this is drawn down, as the private equity manager invests in underlying assets. Then, over time, investments are realised and cash is returned to the investor. This process can take seven to 10 years and the investor is likely to see a negative cash flow in early years, before it turns positive. For this reason, experts talk of the “J-curve” profile of returns when investing in private equity vehicles. According to Harper, the Jcurve can be alleviated: “We continue to build yielding strategies into our diversified private equity portfolios. It can be very useful to have running yield in the current environment, and it can help with the dynamics of a private equity portfolio, to help counter the J-curve effect of a traditional private equity fund.” Yield can be built into private equity strategies by either using secondary fund, which are more mature, or by investing in assets which produce an income, such as infrastructure or real estate debt.
It is impossible to give a meaningful typical asset allocation for local authority funds towards private equity, because some funds will not invest at all, while others, like Merseyside, have a long track record in the asset class. So this should be borne in mind when looking at figures such as the average allocation of 4.4% from a recent WM survey. At present, local authority funds have a 15% upper limit on funds in limited partnerships – the normal format for private equity – though this may be raised. In fact, where local authorities are close to the 15% limit, it is normally because they are investing in other assets, such as hedge funds, property or infrastructure, as well as private equity.
Finally, it should be said that one advantage of the illiquidity of private equity is that it is hard to get out of the asset class when times are hard. This means investors tend to hold on and see performance come through over time. So in the future, if listed markets remain volatile and driven by policy makers as much as they have been, it could be an advantage to have some assets in private equity, where
good managerial skills can quietly add value to a business, before it is sold on when the time is right. Sometimes being an unsung hero can be a very good thing indeed.