Written By: Ray Maxwell
Private equity has become a feature of most pension funds’ asset mix but it is still not particularly well understood. Allenbridgeepic’s Ray Maxwell notes that within the UK economy, private equity is one of the most significant agents of change and, as banks become reluctant to lend, it is a principal source of funding for growth businesses.
Private equity has been around for over 30 years but it is still little understood, much less appreciated. It is an easy target for politicians and, in Germany in 2005, Franz Müntefering of the Social Democratic Party (SDP) referred to private equity firms as “a swarm of locusts”. While this comment made good copy, it could not be further from the truth, as the primary objective of private equity is to create value and not destroy it. Private equity is a significant area of activity that touches a vast array of businesses across the globe at different points in their life cycle.
Private equity has grown exponentially since the early 1980s due to a combination of factors. Initially institutions, including pension funds, allocated no more than 0.5% to 1.5% of assets under management to the asset class but, as track records emerged, allocations became more significant to capture a meaningful level of alpha. Allocations advanced, settling at around 5% of assets under management. However, in the USA, prior to the financial crisis, a number of endowments threw caution to the wind and increased their allocations to 10% to 25% of assets under management. Private equity has also benefited from the surge in institutional assets under management that has taken place over the past 20 years. According to Towers Watson’s Global Pensions Study 2012, in the UK for the period 2001 to 2011 pension assets had more than doubled. The combination of the numerator and denominator effect resulted in a private equity fund-raising bonanza and discrimination flew out of the window as the good, the bad and the downright ugly companies received funding. Since the financial crisis, investors have become more discerning, backing private equity firms that have a solid franchise and a history of performance. The European Venture Capital (EVCA) provides a rather dry definition of private equity, stating: “it is the provision of equity capital by financial investors – over the medium or long term – to non-quoted companies with high growth potential.” This rather understates the impact that private equity has had in making enterprises more profitable, creating jobs and providing investors with a reasonable risk-adjusted rate of return. Because investors are locked in, they require a return that will compensate them for illiquidity and, in general, the accepted premium should be in the range of 2.0% to 3.5% over quoted markets. This could also be considered as the price of uncertainty because private equity investments may be held for upwards of five to seven years and, therefore, as holding periods increase, so does uncertainty.
Private equity is a very broad church and encapsulates a variety of activities from taking private large divisions of quoted companies to the provision of growth capital to SMEs (Small and Medium Sized Enterprises). In the United Kingdom, private equity firms tend to focus on specific areas of expertise.
The major activities are:
• Management buyouts which facilitate the transfer of ownership of companies from owners to managers. Buyouts are commonly financed by a combination of bank debt and equity.
• Expansion capital which provides SMEs with capital to grow organically or finance complementary acquisitions. Funding is usually in the form of equity.
• Mezzanine investment which provides capital, usually in the form of loans with warrants attached to acquire equity at a pre-determined valuation. Its role is to bridge the gap in a transaction between the level of debt that a bank is prepared to offer and the amount of equity that will make the transaction viable. The mezzanine provider is paid out after the bank but ahead of the equity.
• Turnaround and distressed investment which provides capital to businesses that require significant operational improvement or are under severe pressure due to weak balance sheets. The returns required are higher than conventional private equity to compensate for the higher level of risk.
• Institutional buyouts where large private equity firms, with substantial capital available, bring in their own managers to acquire large companies or take public companies private. Since the financial crisis, fewer of these types of transactions have been concluded because the primary source of financing is bank debt.
A key feature that distinguishes private equity investment from public market investment is that private equity firms usually acquire controlling stakes in their investee companies or, even if they hold a minority position, can exercise influence through well-crafted share subscription agreements. This means that private equity firms are able to determine the destiny of their investee companies and effect change without exposing them to the glare of public scrutiny. The management of companies controlled by private equity are generally held to a much higher level of oversight than public companies and rewards are directly linked to achieving milestones. In the short term milestones could include a reduction of costs, but in the longer term the objective is to grow revenues and increase profitability. This is frequently achieved by a combination of investing in plant and equipment, along with training the workforce. This is not a magnanimous gesture but good business sense, as these investments have to be realised and prospective acquirers will pay a premium for well-managed, efficient companies.
This is not to say that all private equity transactions are successful and rates of return tend to conform to a normal distribution. The British Venture Capital Association’s (BVCA) Private Equity and Venture Capital Survey 2011 showed that for all vintage years (the year when a fund is formed) there was a difference in fund performance between the 10th and 90th decile points of 45%. The range in returns demonstrates the difficulties in identifying the opportunities with potential and bringing them to fruition. Not only does a private equity firm have to buy keenly but it has to back a management team that is capable of executing a business plan. Moreover, it has to be able to sell the investment at a premium valuation to generate the expected rate of return. In many ways it is the financial equivalent of juggling spinning plates, and anything that can go wrong will go wrong. All private equity firms will extol their virtues, therefore it is important to carry out detailed due diligence to separate the wheat from the chaff. This is not to say that investors should invest with the same groups all the time, as they do change over time and may lose their drive and tenacity. It is often newer teams that will put in the hard yards to achieve superior returns and establish their credibility.
The major problem, since 2008, has been the decline in the level of Mergers and Acquisitions (M&A) due to weak business confidence. The result has been that private equity holding periods have increased and the distribution of proceeds has become intermittent. However the flip side is that as banks have been impelled to withdraw from the market, more companies – particularly SMEs – are looking for finance. Consequently entry valuations are substantially lower than they were five years ago when risks were perceived to be lower than now. The fact of the matter is that risks were actually much higher in 2008 due to a combination of cheap debt and unrealistic expectations. As expectations have fallen so has risk and, in current market conditions, private equity firms can acquire companies at reasonable valuations. Private equity is not totally linked to GDP, and within the UK economy there are a number of areas that are experiencing rapid growth including business services, healthcare and education. These are areas which will benefit from private equity financing, and it goes without saying that returns are much improved by investing at the bottom of a cycle rather than at the top.