Written By: Robert Coke
Head of Absolute Return and Buyout Investments
The Wellcome Trust

For the Wellcome Trust, private equity has been a surprisingly consistent asset class which has delivered returns at a consistent premium to the public markets over a couple of decades. Robert Coke of the Wellcome Trust discusses some of the possible reasons for this performance.

Private equity encompasses a number of strategies where managers are usually investing in unlisted companies, or on occasion taking listed companies private. The ownership can be control, or noncontrol; the financing can be all equity for younger, faster-growing companies, or include debt to lever the equity in more mature and stable companies.

Is leverage the reason that private equity outperforms?
In the 1990s the private equity industry was nascent. Early leaders such as KKR and Blackstone realised that leveraging a company in a ringfenced entity was a tax-efficient and low-risk way of enhancing returns in what were then attractively-priced assets. The tax advantage comes in that interest on debt reduces profit, and therefore corporation tax. Over the years the debt markets have become deeper and more elaborate meaning that capital structures can be used to optimise company balance sheets. The disadvantage that has arisen is that availability of debt has allowed private equity houses to pay higher prices, meaning that prices in the private market have risen faster than in public markets and are now similar, or in some cases higher.

Leverage per se may only therefore be a marginal advantage now, but the structuring of it continues to benefit private equity. To many, it was surprising how few private equityowned companies went into bankruptcy during the recession. This is because of the notorious “covenant lite” debt and the flexibility of private equity to buy back debt of portfolio companies when it traded cheaply. Much is made of leverage in private equity in that it adds risk to transactions, and it is often said that if public companies had similar leverage, they would make similar returns on equity. In my view, optimising capital structures is a skill in private equity that leads to outperformance, but it is not the main reason that the asset class outperforms.

Does private equity make its returns from market timing?
As capital has been raised in private equity the competition for assets has increased. Private equity is able to time its investments allowing it to “market time” and indeed its structure allows it five years (sometimes six) to invest the capital it raised, on full fees, giving it no incentive to race to invest. Nevertheless, investment pace seems to be pro cyclical meaning most firms invested too much capital in 1998/1999 and 2006/2007 giving them long hangovers. Additionally, prices of private companies have held up surprisingly during the recession. Hence I do not think that outperformance in private equity can be attributed to market timing, and indeed, current valuations are not an argument for private equity anyway.

A superior corporate governance model?
Given that valuations are high, economic growth is slow and private equity fees are high, how can private equity managers make returns that compensate investors for the illiquidity of the asset class? This has been the subject of much research, but the answer to me lies somewhere in the superior corporate governance of private equity. Boards tend to be comprised of the company’s executives and private equity specialists which mean decisions can be taken quickly and effectively. This was most obvious actually in 2008/9 when sales were plunging for most companies, yet again and again private equity owned companies were able to cut costs to keep their earnings stable or slightly negative year on year. At other times, private equity is able to take a longer-term strategic view, often increasing capex early in the ownership cycle or taking advantage of weak periods to inject further capital to allow its companies to capture market share.

Spoilt for choice
There are, of course, many different private equity firms and strategies to choose from, and any number of criteria one might use. Among the more important are:

  • Proven ability and ensuring that those who have the ability are still active in and tied to the firm
  • Ensuring alignment of interest
  • Judging the likely effectiveness of the strategy over the lifetime of the fund (usually 10-12 years)
  • Understanding the market positioning of the firm and its ability to close deals

Strategies vary from buying companies valued at over $1 billion to at the smallest end buying companies worth $10 million. There are control strategies and those who buy minority stakes, usually in fast-growing companies. There are strategies that involve taking control of distressed companies by buying their debt, or buying them out of bankruptcy. And of course there are geographically focused strategies, where local peculiarities need to be understood, such as bankruptcy processes, rights of equity vs debt, dealflow and differing standards of corporate governance. Choosing between all these alternatives requires experience.

What are the drawbacks?
Private equity funds are structured with ten year lives that are usually extendable to twelve. Funds are drawn down over the first half, and investments realised over the second half. While the investment is underway the power of the investors (Limited Partners) is very limited. The secondary private equity market is now very active and it is usually possible to sell LP interests, but usually at a significant discount to its real value.

The fees in private equity funds will generally reduce internal rates of return by about 5% per year. So while private equity firms tend to aim for 20% IRRs, the investors will end up achieving between 10-15% usually. As they get bigger, income at private equity firms increases faster than its costs and the largest firms are very profitable. On top of this many charge fees to portfolio companies and there is a concerted effort to remove this misalignment from the industry. Carried interest is paid on profits generated above a certain hurdle, ensuring that, at least for the smaller funds, managers are only well paid when they generate good profits for investors.

The complexity of investing in private equity does put off many investors, and the industry repeatedly pleads for more standardised benchmarks and terms. Understanding a limited partnership agreement or a private placement memorandum requires specialist expertise that most pension funds are not willing to pay for. Accounting and cashflows are also administratively burdensome.

What should I do?
Private equity had a “golden era” of returns prior to the recession with plentiful and cheap debt, rising valuations and a good economy. It seems likely that returns will reduce although the ability to outperform public markets should remain due to the advantages of the corporate governance model.

New entrants to the asset class should take time to consider their strategy and their cashflow ambitions. The “J-curve” effect due to front loaded fees means that the portfolio would initially be valued below cost, but there are ways of flattening out the J-curve by investing in funds that will return capital more quickly. Investing with the expectation of not reaching cashflow breakeven for 7-8 years is prudent.

The complexities of understanding the terms and knowing the market mean that specialised knowledge is recommended. Funds of funds are an obvious first step, but they will erode returns, often taking away any illiquidity premium over public markets. Hiring internal talent if your assets are big enough to justify it is the best way to invest in private equity and, if not, sharing talent with a few other similar funds would be an interesting alternative.


More Related Articles...

Published: January 13, 2013
Home » Why consider private equity for your portfolio?

More Related Articles...