Listed private-equity funds can offer individual investors superior returns. But picking the best funds requires extensive analysis, says Frederic Guirinec.
In the past, private-equity firms were criticised as locusts and barbarians. Today, despite some high-profile failures in the wake of the financial crisis, private equity has grown to be part of the investment mainstream, managing around $4.3trn in assets.
The volume of deals and capital raised continues to grow and many familiar companies are owned by private equity, including Scandlines, New Look, Odeon, Pizza Express and Agent Provocateur.
The growth of private equity is mainly explained by the consistent outperformance that private-equity fund managers have delivered to investors. Over the last ten years, private-equity funds have achieved an annual return (as measured by internal rate of return – “IRR”) of 13.2%, compared with 5.6% for the FTSE All-Share index, according to the British Private Equity & Venture Capital Association.
In 2016, private-equity funds generated an 8% annual return in 2016 versus close to zero for hedge funds. However, these performance figures hide significant discrepancies between top quartile and bottom quartile funds, demonstrating the need to be selective when investing in private-equity funds. More than in any other sector, the selection of fund managers requires experience and expertise.
Understanding private equity
It’s important to keep in mind that private equity is a general term that includes venture strategies (funding small, fast-growing business) and buy-out strategies (buying existing firms). I favour buyout firms that typically focus on “mid-cap” companies, because larger companies are more difficult to manage and require time and expertise. The private-equity fund managers, who are also referred to as general partners (GPs), have different strategies in terms of sector, geography or investment size.
They aim to create value through three ways:
1). Finding undervalued investment opportunities. This is challenging today, as market valuations are close to record levels.
2). Financial engineering. This involves taking advantage of low interest rates to leverage up companies with borrowed money (and sometimes to fund small acquisitions or “add-ons” at lower valuation multiples). Higher leverage can improve tax efficiency – since interest costs are tax deductible – and imposes a stronger discipline on companies’ management.
3). Operational value. This includes cutting costs, outsourcing production, investing in brand growth, internationalising operations and marketing.
Investors need to focus on finding managers who add operational value. Those who “pass the parcel” – buying from and selling to other private-equity managers – should be avoided. Although a simple strategy of buying sound, cash-generative portfolio companies without changing them has delivered a decent track record in the past, it does not justify the high level of fees that private-equity funds charge investors. Generally, investors pay a 1.5%-2% annual fee based on the amount of capital committed and a performance fee of around 20% of returns so long as a certain hurdle rate (say, 8% per year) is exceeded. For that level of fees, investors should demand managers add real operational value.
Direct investment in private-equity funds remains mostly the preserve of institutional investors. Lack of liquidity and accessibility are the main deterrents for individual investors. Minimum commitments will be millions of pounds.
Once the investor, known as the limited partner (LP), has committed to invest a certain amount, the private-equity fund manager will call the capital in stages over the investment period, usually the following five years, to fund the acquisition of companies. Investments will usually be held for three to seven years, after which the GP will sell the company to another private-equity fund, a trade buyer, or will list through an initial public offering. Consequently, it takes a few years to get your initial capital back and up to 12 to 15 years to realise all the returns.
However, there is a practical way for individuals to invest in private equity: public private equity. This may sound like an oxymoron, but it refers to private-equity funds that are listed on the stock exchange, which solves the two issues of accessibility and liquidity. The main challenge for investors is to understand what the strategy of the fund is and how to value it appropriately.
Using the fund’s discount to net asset value (NAV) is of limited use, as the valuations are made by the GPs themselves and only published once or twice a year. Discounts can vary depending on market sentiment, the perception of performance of the private-equity sector, the liquidity of the listed fund, the reputation of the fund manager, the portfolio’s diversification and the strength of the balance sheet.
The analysis challenge
Investors who want to dig into these funds will need to take account of each fund’s portfolio of investments, its performance, diversification, vintage (when the investments were made), recent acquisitions, returns realised on exits and the conservativeness of the portfolio valuation.
In some cases where the management firm is part of the listed entity, investors may have to value the management business and add it to the NAV. This can explain why some funds are trading at a premium (3i’s shares trade at over 700p, compared with a NAV of 551p). In this case, investors must also consider the strategy of the fund manager, source of management fees, stability and reputation of the team and recent or ongoing fundraising. Use a discounted cash flow or price/earnings method to value these activities and add the valuation to the NAV.
Be cautious when dealing with fund of funds, in part due to the extra layer of management fees, which act as a drag on returns. To offset the fees and to add value, these managers buy assets leveraged on the secondary market (ie, they buy private-equity investments that other investors are exiting or invest in other listed private-equity funds), applying greater leverage.
The combination of high leverage and acquisitions of mature private-equity funds has allowed some funds of funds to delivered tremendous returns. However, this sector has attracted large amount of capital: for example, Ardian and Lexington have raised $10bn funds. The recent high-profile takeover of SVG Capital, an underperforming London-listed private-equity fund, by US fund HarbourVest is a red flag illustrating that too much capital is chasing too few assets.
Investing in listed private equity can offer good opportunities. I’d favour small, direct private-equity firms. But be ready for lumpy returns and take a long-term view, planning on a holding period of at least five years.
What to buy and what to avoid
3i (LSE: III) has been an outstanding performer over the last three years. 3i has some of the most transparent reporting, but in my view the portfolio is too concentrated (Action, a Dutch discount retailer, represents 30% of NAV). In addition, 3i’s strategy, following the sale of its private debt business is unclear. But 3i Infrastructure (LSE: 3IN), its infrastructure fund, could be a speculative buy, since 3i may decide to sell it.
Another popular choice is Hg Capital (LSE: HGT), which has a clear expertise in telecoms, media and technology, and software services. It has a consistent and strong track record in the sector. Electra Private Equity’s (LSE: ELTA) share price has increased significantly in 2016. The discount to NAV looks attractive, at 7.8%, but I would avoid it as a result of recent changes in management and strategy. Listed private-equity companies in France seem to offer more obvious value than those in the UK at present.
Eurazeo (Paris: RF) is a well-known name. Its portfolio was struggling a few years ago and remains cyclical, but it is recovering nicely. Clothing firm Moncler and car-hire group Europcar are strong performers. Altamir (Paris: LTA) is run by Apax Partners. It trades on a significant discount to NAV of 40%, yet the portfolio is well diversified and seems conservatively valued. Average leverage stands at 4.1 times earnings before interest, tax, depreciation and amortisation. Half the portfolio was acquired in 2012 or before and includes names familiar to long-standing private equity investors.
Perhaps best of all is Wendel (Paris: MF), which is closer to the roots of private equity: it has family offices making direct investments. Its shares trades at a 22% discount to NAV. Over half of the portfolio includes two listed firms: St Gobain and Bureau Veritas. The rest of the portfolio includes unlisted companies mainly in the industrial sector. Valuing the listed part of the portfolio at market prices, the rest of the portfolio trades at a discount of 38%.