Rewarded For Lock-ups
Asset Classes (8): Private Equity
Private equity has enjoyed a high profile as an asset class in recent months, as firms have made public their intentions to bid for some large JSE-listed companies such as Edcon, Shoprite and Alexander Forbes - and Primedia, the first target to sail into view in 2007.
But private equity has existed as an asset class for far longer than some of the other so-called alternative asset classes, such as hedge funds. Old Mutual, for example, set up its private equity portfolio (then called the unquoted portfolio) in the 1970s.
Worldwide, total private equity investments exceed US$900bn. In SA, a total of R43,9bn is invested in private equity - which is a higher percentage of GDP than achieved by the private equity industries in the UK, the Netherlands or Sweden. Private equity refers to any type of ownership in a company or enterprise not listed on a public stock market.
The formal private equity industry consists of:
- Captive firms (such as Standard Bank, Investec and RMB's private equity arms) that manage a parent company's assets; and
- Independent firms (Brait and Ethos are the most prominent ) that raise cash commitments from third-party investors.
There is also an informal private equity industry made up of entrepreneurial "business angels" such as Eric Ellerine and Christo Wiese.
Private equity investments can be divided into several categories: the most risky is the provision of start-up and seed capital, known as venture capital. But this currently accounts for just 12% of private equity investment in SA.
A further 15% is being invested in established companies that are still in their development stage. But the SA industry is focused on the buyout of mature companies, which accounts for 73% of private equity investment.
The European Private Equity & Venture Capital Association describes private equity as "investing in securities through a negotiated process". Private equity capital is used to develop new products and technologies, to expand working capital, to make acquisitions or to strengthen a company's balance sheet. It can be used to resolve ownership or management issues, succession in a family-owned business or the buyout or buy-in of a business by experienced managers.
The biggest drawbacks of private equity investments are the costs, when compared with listed equities and bonds, and the lack of liquidity. Private equity funds charge a fee of 2% of committed capital and take a 20% share of realised profits.
According to a recent paper by Momentum on private equity, the costs of investments reduce the returns of the established private equity funds in SA by 6%, but this is arguably justified by the premium which has been achieved.
The 11 private equity funds surveyed by Momentum have provided an 18% return premium before costs over the Alsi. CONT... Paul Boynton, head of alternative investments at Old Mutual, says that in the US, where there is a much longer history and more comprehensive information, private equity has provided a 4%- 5% premium over listed markets over the past 50 years.
Ivan Missankov, an actuary at Momentum, says private equity funds are able to maximise returns as they have time to carry out thorough due diligence investigations. They can often negotiate to buy at a bargain price and after five to seven years when the cycle has turned, or a business's reputation has been restored, they sell or relist the company.
Private equity firms are actively involved in the companies in which they are invested and will often take board positions. They can also maximise returns on equity by taking on significantly more debt than most institutional investors will tolerate in public companies.
Private equity firms do not just make traditional equity investments. They also provide shareholder loans and various forms of debt and bridging finance. They can afford to take a long-term approach because their investors have committed capital for 10 - 12 years.
Private equity firms will typically announce that they plan to raise money for a new fund and will take several months to do so, and when it is fully subscribed it will be closed to new business. There is what is known as a J curve in the investments. There are losses in the first three years as this is the time it takes to commit the funds, but usually no investments are sold during the early years. But private equity firms still charge a fee as they need to pay people to carry out the due diligences and negotiate the best deals.
The fund can take up to six years before it delivers its maximum internal rate of return, which takes place when it starts to sell out of its investments.
There are international guidelines which revalue the underlying investments of private equity funds before they have been sold - and investors will earn interest and dividends from the investments. But in practice, the bulk of the profit on private equity investments is made when they are sold.
In some of the large developed markets such as the US, there is a secondary market in which investors can sell on their interests in private equity funds.
Unlike conventional investments such as unit trusts, you cannot sell your interest in private equity back to the management company.
Even investors in the endowment policies which invest into private equity, such as the Momentum and Old Mutual funds of funds, either cannot surrender their policies or else will be charged very high surrender penalties, at least in the first five years.
So generally only investors with long-term investment horizons can invest in private equity. In SA, government and development finance institutions such as the Development Bank of SA accounted for 58% of third-party investment into private equity funds, corporates for 14%, banks for 10%, and insurance companies and pension funds for 6% each. Boynton says that life assurers should invest a portion of their annuity funds into private equity, as they can provide more attractive payouts on a 12 to 15-year investment horizon than long-dated bonds.
Individual investment in private equity remains negligible, mainly because minimum investments in private equity funds are usually at least R20m, and because there have been only two retail private equity funds-of-funds so far - and Momentum required a minimum investment of R1m, Old Mutual R50 000.
David Swensen, the chief investment officer of the Yale Endowment Fund, and one of the leading international investors in private equity, argues that private equity is such a lucrative investment because investors generally overpay for the right to liquidity.
"Private equity investments clearly illustrate the significant returns that can be gained from having a long-term investment horizon and no short to medium-term liquidity requirements.
"In this context, a private equity investment is nothing other than pure liquidity arbitrage," says Swensen.
Missankov says that pension funds should consider investing in private equity in spite of its illiquidity, if limited to no more than 10% of total assets - particularly as successful funds will provide significant cash flow through the life of the investment. But so far only the very large pension funds, with assets of more than R15bn, have invested in private equity funds.
Individuals with a long time horizon should be able to benefit from the superior returns of private equity, but few financial advisers have the expertise to help investors choose the right funds. The trick is to choose the right manager. In the Momentum sample of 11 funds, the worst performer underperformed the JSE by 3,3%/ year.
But regardless of the choice of manager, private equity has a very low correlation with other asset classes - because its return pattern will be so different, it is an excellent diversifier, with a correlation of just 0,1, or 10%, with the listed equity market.