Private equity is now firmly part of the investment mainstream, thanks to a record of strong returns. Over the last ten years, European buyout funds have achieved an annual return (as measured by internal rate of return, or IRR) of 15%, according to the European Private Equity and Venture Capital Association. By comparison, the FTSE 250 index – a proxy for the type of mid-sized companies that these funds often invest in – has managed a total return of just 8.8%.
However, these headline figures disguise a lot of variation. Globally, the top quartile of buyout funds returned over 20% while the bottom quartile barely made a positive return, according to private-equity giant Bain Capital. This shows the need to be selective and the challenge of picking winners. That’s also true of managed funds that invest in listed assets, but there are significant differences between how traditional funds work and how private equity works. Investors should make sure they understand how these returns are achieved, whether they can be sustained and what could be the best way to profit from the boom.
A large, long-term commitment
Private equity (PE) is fundamentally an asset class for large financial institutions – the fact that individual investors can get involved through listed funds is a sideshow. The minimum commitment to each PE fund can be millions or even tens of millions of pounds, so the amount of capital that must be allocated to construct a diversified portfolio of funds is substantial. With demand from institutions now strong and the amounts being committed very large – $300bn (£215bn) for buyout funds last year – this is an excellent business for successful managers. They can raise a fund every four to five years, with an average size of close to $2bn (this is skewed by the ability of the top managers to raise giant buyout funds of around $20bn). The manager’s brand has become a key factor in deciding where to invest for many institutions, especially since the outcome of an investment takes a few years to materialise, which helps established managers gain and retain market share.
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The multi-year time frames of private equity are highly beneficial to the managers. Once the investors – who are known as limited partners (LPs) – have committed to invest a certain amount, the private-equity fund manager – or general partner (GP) – will call the capital in stages over the investment period to fund the acquisition of companies. This phase will usually last five years. Investments will usually be held for three to seven years, after which the manager will exit by selling the firm to another private-equity fund or a trade buyer (another company in the same industry), or listing it on the stock exchange through an initial public offering (IPO). The fund may be able to make some distributions to the LPs relatively soon if the investments are performing adequately, but it takes a few years to get one’s initial capital back and up to 12 to 15 years to realise all the returns.
Meanwhile, PE managers can generally charge 1.5% management fee on committed capital (even though it is not invested yet) and take a performance fee (known as carried interest) – typically 20% – if the fund achieves returns above a certain rate (an internal rate of return, or IRR, of 8% is common). The manager may be able to use bridge financing (short-term loans taken out with the intention of replacing them with longer-term funding) to postpone the call of capital or to accelerate distributions, both of which help juice the IRR by altering the timing of cash flows. (For this reason, you should not look solely at IRR as a measure of the manager’s returns, but also look at the multiple – what it paid for the company and what it’s now worth.)
The secret of their success
When a PE manager sets out to raise a new pool of capital, the detailed documentation (known as the private placement memorandum) will underline how they will deliver returns by finding undervalued firms and adding operational value to them by cutting costs, outsourcing production, investing in brand growth and internationalising operations. However, the true skill of PE managers is financial engineering. They take advantage of low interest rates to gear up their investments (and often to fund small acquisitions or “add-ons” at lower valuation multiples that grow the size of the businesses quickly). Higher leverage improves tax efficiency because interest costs are tax deductible, it imposes financial discipline on the firm’s management and magnifies returns if all goes well. It also supports high prices: the ratio of enterprise value (equity plus debt) to earnings before interest, tax depreciation and amortisation (EV/Ebitda) on new deals averaged 11.4 in the US and 12.6 in Europe last year (versus a past average of between eight and nine), with over half of deals geared above seven times Ebitda.
Given this environment of abundant liquidity, many GPs content themselves with a game of pass the parcel: one manager who has raised a fund acquires a firm from another who needs to exit, adding additional debt along the way. Two or three years after acquisition, the portfolio firm may be refinanced to pay a dividend to the PE fund, even though this will leave it carrying yet more debt.
Most of these acquisitions are financed by leveraged loans, or increasingly misnamed “high-yield” bonds (where yields are below 4% in the US and 3.5% in Europe). The bonds are usually rated at B, well below investment grade (BBB), while quality of leveraged loans is also dropping. Nowadays, more than half of leveraged loans are acquired and packaged up by collateralised loan obligation (CLO) managers, who may raise fresh funds every quarter and are under pressure to deploy capital swiftly. Consequently they have little room for negotiation, which results in very poor underwriting standards: 94% of new leveraged loans are now cov-lite (ie, they carry hardly any financial covenants to protect the lenders).
Playing hardball with lenders
Some highly leveraged borrowers will default as a result of the current economic crisis. Rating agencies expect corporate default rates to increase from 4% to 8% in 2021. This will apply to PE-backed firms as well: 10% of US PE-owned firms are reported to be in “intensive care”, fully drawing down their revolving lines of credit and requiring injections of fresh equity. Higher defaults will weigh on future returns for PE funds.
Still, during the global downturn in 2008, PE-backed firms outperformed others, in part due to the assistance that their owners can provide in a crisis. Buyout funds have $1trn in “dry powder” (the industry term for cash waiting to be invested), which may be used to inject fresh equity. They are also expert at negotiating with lenders, who will know that weak covenants and high leverage mean they are unlikely to recover the historic average of 70 cents on the dollar if the borrowers default. Consequently, lenders may be receptive to amending and extending existing loans, or swapping debt for equity.
Buy the fund cheap – or buy the manager
Listed PE firms are “evergreen” in nature, meaning they have permanent capital. They reinvest proceeds from the sale of investments into new investments, but at any given point there will be existing “seasoned” investments in the portfolio. This is important because you need to take into account how well these seasoned investments are probably performing, as well as the manager’s record on exited investments, to decide whether a fund’s premium or discount to net asset value (NAV) is attractive.
NAVs can lag reality in a positive way: a successful investment will be worth more than the book value on the accounts. But when an investment is struggling, NAV will decline more slowly than reality: managers will try to step valuations down gradually to avoid worrying their LPs. Right now, the prospects for certain businesses – such as restaurant chains and other leisure operators – remain unclear, so bear this in mind with trusts that are directly or indirectly invested in them.
Decent trusts now on discounts include Apax Global Alpha (LSE: APAX). The underlying portfolio is robust, but it looks fully valued: 60% of the portfolio firms are valued above 14 times Ebitda. However, when the trust’s own discount is wide enough, that doesn’t matter and it’s back out at 11%. Outside the UK, Wendel (France: MF) trades at 34% discount. Its share price has disappointed since 2018, but it remains a strong manager: it sold security firm Allied Universal last year for a 2.5 times return. Meanwhile, shareholders should pressure funds of funds with large discounts such as HarbourVest (LSE: HVPE) and Pantheon International (LSE: PIN) to sell assets to other PE buyers to close the discount (whether they will is another matter).
Alternatively, investors should consider buying the managers. 3i (LSE: III) is both an investment portfolio and the management business for other 3i funds. The NAV does not ascribe any value to the manager, so it always trades at a large premium. Eurazeo (France: RF) is similar, but trades at a discount (now 24%) because of its exposure to ailing car-rental firm Europcar. The rest of the portfolio is sound and it raised €2.8bn to manage in its external funds last year.
The founders of management firms such as Apollo, Carlyle and KKR have also sought to raise cash through IPOs in recent years. They mostly earn from fees and carried interest (with few direct investments) and valuations imply the market thinks this is where the real value lies in private equity. Partners Group has a market capitalisation of CHF30bn (£23bn), or a third of its assets under management (AUM), while shares in EQT have risen 300% since it listed in September 2019. Its market cap of SEK261bn (£22bn) is half its AUM, while its EV/Ebitda is a staggering 70 times. That’s too steep, but Apollo Global Management (NYSE: APO), with a market cap of $20bn (including $3bn in investments) against AUM of $450bn looks cheap.
Frederic is an investment analyst. He started his career at JP Morgan in Paris. He has more than ten years of experience investing in private equity and also worked with the 3i debt management team investing in private debt. He is an ACCA member and a CFA charterholder. He graduated from Edhec Business School.
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