The current market turmoil has led investors to reassess traditional portfolio management. Tim Smith, of Conversus Capital, highlights the advantages of holding private equity funds alongside or instead of LP funds...
The market turmoil and credit crunch we are experiencing globally has challenged traditional portfolio management theory. Fund managers have found that, in these extreme market conditions, portfolios that were diversified in order to reduce risk and maintain returns have not necessarily delivered what was expected.
However, the difficulties we are experiencing should only serve to strengthen the resolve to apply a disciplined approach to diversification across asset classes and geographies. As we emerge from this turmoil, a shift in diversification strategies will cause renewed attention and allocation to various alternative asset classes to ensure clients have a full range
Private equity has been used and understood as an alternative asset by fund managers for many years. Europe has 80 tradable private equity vehicles with a combined market capitalisation of approximately £15bn (€16bn). These companies, which include single managers such as HgCapital and Dunedin and funds of funds such as Conversus, F&C and Pantheon, enable individual, endowment and institutional investors to access diverse portfolios of individual companies or funds.
Fourteen of the UK and continental listed private equity vehicles are members of Listed Private Equity (LPEQ), a trade body established in 2006. These companies have been keen to learn more about how institutional investors use listed private equity as part of their investment strategies. To that end, LPEQ commissioned Preqin, a leading source of information on the alternative assets industry, to survey 100 institutional investors, of varying sizes and types, across Europe. Almost all the institutions polled were already investors in private equity limited partnership (LP) funds. The research was conducted in September-October 2008.
The findings showed that institutional investors familiar with listed private equity had confidence in the asset class over the long term and tended to maintain their holdings for a significant period to ensure they benefitted from the long-term nature of private equity returns. However, many investors for whom listed private equity offers a strong fit either did not know of listed private equity’s existence or knew little of its characteristics.
Of the total sample, 27% either held or had previously held listed private equity investments, representing half of those permitted by their investment mandate to invest in listed private equity. While 26 of the respondents represented UK institutions, only six of the UK respondents held or had held listed private equity stocks. Swiss investors surveyed represented the largest number of investors holding listed private equity.
With regard to size, smaller institutions with assets of up to $1bn (€0.75bn), favoured listed private equity marginally more than larger institutions that naturally had more access to direct investments in private equity LP funds. Insurance companies, family offices and endowments were among the most likely to invest in listed private equity.
These investors benefit from the flexible investment amounts that can be put to work in listed private equity. In addition, investors do not have to wait for distributions from LP funds to generate liquidity. They have the ability to sell the public shares of listed private equity companies at a time that best suits their liquidity needs. To support this notion, liquidity was cited as the foremost advantage of listed private equity.
The second most important advantage of listed private equity noted by respondents was the ability for investors to gain immediate access to portfolios diversified by vintages, sectors and geographies. This diversification allows investors to avoid the J-curve effect of investing in LP funds at the beginning of the fund’s life.
In addition to noting liquidity and efficiency as benefits, almost two thirds of the total sample thought the reduced administration load and increased cash management flexibility of listed private equity made listed private equity an attractive complement or alternative to LP funds.
As additional evidence of the complementary nature of listed private equity to LP funds, 82% of listed private equity investors believed they could reach and manage their private equity allocations more effectively by investing in listed private equity alongside LP funds. Although current holders of these stocks indicated they may adjust their holdings depending on their allocation to LP funds, they saw the listed segment as a long-term commitment. Forty-seven percent of investors held listed private equity stocks for five years or more, underlining the long-term nature of the asset class.
We noted that institutions take a different approach to listed private equity from that of the wealth managers LPEQ has previously surveyed. Whereas wealth managers took a portfolio approach to listed private equity, with investors holding a median average of six different stocks at any point in time, institutions appear to be more selective. Of those disclosing information regarding their holdings, 75% held shares in three or fewer listed private equity companies.
Lack of consideration
The remarkable finding in the survey was that very few institutions knew about or considered listed private equity investments as part of their allocation to the asset class, in spite of the listed sector’s strong long-term outperformance. For the ten years ending 31 December 2008, the compound annualised total return from the FundData IT Private Equity NAV index, excluding 3i, was 10.9%, while from the FundData IT Private Equity Price index it was 3.3%. This contrasts with compound annualised total returns from the FTSE All Share of 1.2% and 1.3% from the MCSI World Index (Source: FundData.com).
Of those surveyed, 53% did not have a mandate to invest in listed private equity. However, the main barrier to listed private equity funds expanding their investor base was insufficient knowledge, with 30% of the total sample saying they lacked adequate information to invest in listed private equity stocks. External sources of information on the sector are disparate, ranging from LPEQ to indices like LPX and share information providers like Fundamental Data (Morningstar). Surprisingly, only 24% of those investing in listed private equity received broker information on the sector, despite the deep focus on the listed private equity space by such sophisticated brokers as Cazenove and Collins Stewart.
Just as alarming, consultants also appear to be failing to advise institutional investors about the listed private equity sector. Only 26% had received information from their consultant about listed private equity, while over half felt such information would be useful.
The LPEQ members have started to focus intensively on the lack of information and understanding of listed private equity in the marketplace.
Time to buy
There is little doubt that 2009 is going to be a challenging year for all segments of the economy, including private equity. But this downturn might also provide one of the best buying opportunities we have seen in almost 20 years for private equity fund managers with cash, as valuations fall and perfectly sound businesses struggle to find capital.
The core strengths of private equity – we are principals not agents, we have alignment of interest between fund managers and limited partners and we bring oversight as well as strategic and operational guidance to portfolio companies – will be in demand through 2009-2010, as our industry becomes part of the solution to pull the world economies out of this unprecedented period of turmoil. History has proven that private equity has dramatically outperformed public markets coming out of times of dislocation, such as we are experiencing today.
This historical evidence is not lost on investors: 76% of those invested in listed private equity in our survey intended to maintain or increase the level of their holdings. Some saw the current discounts to NAV in the sector as buying opportunities and are focused on the value listed private equity offers today.
While we regard this as a vote of confidence from the cognoscenti, we will be working to increase understanding and provide information on this core part of the private equity sector.
©2009 funds europe