The vulture funds picking over the bones of the economic crisis

Private-equity ‘vulture’ funds were brought down by the financial crisis. They’re beginning to regain their feet and take to the skies. David C Stevenson suggests which ones to back.

Private equity didn't have a good financial crisis. Many investors lost small fortunes on the large number of private-equity funds that trade on the London Stock Exchange. The crisis may have been started by rapacious investment bankers, but private-equity managers soon found themselves pushed under the proverbial bus. Was anyone really surprised that private-equity billionaire Mitt Romney lost the US presidential election?

This unpopularity not helped by those plummeting share prices was made far worse by persistent questioning of the business model for private equity, especially in a new normal' economy where debt is supposed to be a bad thing.

Private equity's cardinal sins

In very simple terms, critics charged the private-equity titans with two cardinal sins. The first is that the whole sector was addicted to deal-making on debt, and that this model would collapse as the investment banks withdrew funding for any structure lasting much longer than a few years.

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But perhaps the more damaging criticism was also the most simplistic namely, that there were just too many ex-investment bankers masquerading as private-equity buyout junkies.

The selling point of the sector was and to a degree still is that private equity is all about finding great private firms that, with the right know how, plus the judicious application of capital and financial discipline, can be transformed into even bigger global businesses. These can then be sold on within a three-to-ten-year time frame.

That idea still powers the popularity of respected operators, such as Jon Moulton and his Better Capital listed funds (both of which trade at a premium). But it became evident that returns could also be juiced up simply by layering on debt to the point where even a small uptick in underlying values could generate big profits and big fees for the managers.

As a result, all manner of financial engineering' mushroomed before the crisis. When the crisis hit, it was a nasty reminder to investors that leveraging an investment can be deadly.

But the collapse in investor confidence also knocked a hole in the exit' plan for many private-equity managers. Private equity starts with finding a great, under-nourished business, buying it with loads of debt and some equity, and then re-engineering the business process. But the end game is clear someone else buys the resurgent business back from you, making the private-equity fund a big profit.

That someone' could be either a big public company hungry to make an acquisition, or the public markets through an initial public offering (IPO).

Unfortunately, the financial crisis nixed both exit strategies. Merger activity froze up, while a legion of public enterprises that had once been backed by private equity imploded within just a few years of listing. It got so bad that experienced investors, such as Andy Brough at Schroders, vowed never to buy another private-equity-sourced IPO ever again!

This exit blockage' still not entirely cleared had a devastating impact on confidence. The share value of many listed private-equity firms dived, and massive discounts opened up between their stated net asset value (the value of the underlying companies in the fund's portfolio, usually based on industry guidelines about valuing private assets) and their share prices. Private equity looked doomed as a mainstream alternative investment.

A fair wind blows again

But 2013 seems to have brought with it a fair wind. Suddenly, private equity has begun to look more interesting. Barely a day goes by without some business basket case usually trading on the British high street falling to a private-equity house with big plans to shake things up. This distressed investing' hasn't always helped with the sector's reputation for vulture-like activity. But behind the scenes, mainstream private-equity outfits have started to power ahead again.

According to data from analysts at Numis, a broker, the listed private-equity sector is up 33% over the last 12 months, and a stonking 13% for the year to date. Many well-respected funds are up by more than 40% in the last year, and money is starting to flow back into the sector.

But private investors need to be aware that these gains are largely due to a change in sentiment. As investors have moved back into the sector, discounts have narrowed sharply, from around 35%-40%, to the current average of just over 20%. According to Numis, actual net asset value growth over the last year has been a rather more modest 3%. But that uninspiring number hides a much bigger opportunity.

There's bound to be a lag between improving macro-economic sentiment and the way in which a private-equity fund will account for the value of a portfolio asset. So if the business cycle is turning in favour of private equity, there's grounds to believe that the sector might push ahead at an even faster pace in 2013.

Opportunities abound. The key driver is that companies large and small are intensifying their restructuring process to improve underlying profitability. Unwanted divisions are being sold or shut down. Banks need to quickly wind down their vast corporate loan portfolios and merger activity is increasing rapidly. Private investors might see this cycle at work most nakedly in the high street, but throughout the British business ecosystem activity is intensifying.

If going public is still difficult, and banks are reining in lending, why wouldn't an entrepreneur at least consider a private-equity deal? This almost-Darwinian process of corporate transformation is probably being felt most keenly in southern Europe, especially in Spain and Italy, where private-equity houses are constantly snapping up assets.

For instance, UK-listed (but US-based) outfit JZ Capital Partners has pushed ahead with a number of Club Med' deals targeting world-class companies that just happen to be in the wrong place at the wrong time.

There's also good news coming out from these funds' long-term core holdings in economies such as the US and Britain. More and more portfolio companies are being sold at a profit, sometimes to other private-equity houses, sometimes to big trade buyers. Recent numbers from Pantheon International Participations, a London-listed fund of funds, shows that cash realisations are rising.

This fund generated more than £40m, by way of cash distributions, over the last quarter of 2012, while calls for new money (from underlying fund managers) only totalled £5m. It's not unusual for successful deals in the sector to show gains of three or four times the initial cost, although there are still plenty of deals you don't hear about that lose investors large sums.

Tread carefully

But beware. This marked upturn in sentiment doesn't mean that every private-equity fund is suddenly brimming full of optimism. Quite the contrary, in fact. Wealth managers are now piling the pressure on to poorly performing funds to wind up, and winnow down the bloated size of the sector.

To make matters worse for managers, pressure is also building on funds to cut fees in a sector where many leading players charge anything between 2.5% and 5% a year.

I think it might be worth tiptoeing back into the sector, especially if equity markets regain confidence. Ideally, I'd do it via quality outfits such as Better Capital (LSE: BCAP), but this fund is a tad expensive at current levels. I'd look at buying into HG Capital (LSE: HGT), which is focused on mid-cap buyouts, and Intermediate Capital Group (LSE: ICP), which provides mezzanine financing structures' for private-equity houses.

Both are excellent niche players, with great reputations and decent share prices. For a focus on larger deals, I'd perhaps try SVG (LSE: SVI), which still trades at a 20% discount to its net asset value.

I'd also consider a fund of funds such as Pantheon (LSE: PIN) if this upturn in sentiment lasts. It invests in nearly all the major global funds and has a decent track record, which makes the 25%-plus discount look steep. Last but not least, it might be worth having a look at funds that target specific opportunities.

Business looks strong for American mid-cap-focused outfits such as JZ Capital Partners (LSE: JZCP) although its fees are a bit scary and I'd also investigate NB Distressed Debt (LSE: NBDD).

This is run by American house Neuberger Berman, which focuses on buying debt in good companies with bad balance sheets. It's winding up in 2015 and should be able to target 10% to 20% returns from its portfolio of asset-backed debts.