Making the most of private equity
Short-term fashion or sound investment? Private equity is currently under close scrutiny in the media. There are a variety of polarised views being expressed. Observers warn that the current surge of interest in private equity is causing ‘bubble amnesia’ and are cautioning investors to remember the dotcom sector of the late-1990s. They opine that there is a flood of money coming into private equity funds but too few deals to put the money to work (referred to as an ‘overhang’ – alongside lots of other intriguing jargon). From another perspective, trade unions offer sharp critiques of the industry, making allegations of short-termism and profiteering. UK workers are concerned that a move into private ownership means job losses and cuts to benefits. In the face of this controversy should the investor steer well clear?
Broadening the sphere of alpha potential In the midst of all the press frenzy, it is worthwhile considering why we might allocate funds to private equity. There are a wider variety of equity strategies open to investors than ever before. We have previously discussed 130/30 strategies, the benefits of shorting and, last month, we considered hedge funds. Private equity is often cast alongside these strategies as an ‘alternative’, a diversifier but usually not a substitute for public equity. However, its philosophy is the same – ownership interest in a corporate entity. A large proportion of the world’s economy is in private hands: approximately £910bn (e1,333bn) has flowed into the private equity market over the last 20 years and, in 2006, private equity has financed well-known companies such as United Biscuits, Philips Semiconductors and French telephone directory publisher Pages Jaunes. One difference comes in the form of activism. Whilst public equity owners are generally passive, many private equity investors drive strategy, change management and make operational improvements. What about performance? Last year we saw a 100 per cent increase in global private equity fund-raising to $238.7bn (e181.1bn), and 2006 looks set to exceed that record. The chief attraction is often cited to be the asset class’ return potential. Looking at this more closely, while the average private equity manager has historically delivered comparable returns to the average public equity manager, the top quartile private equity managers have outperformed public markets by a wide margin – often more than 10 per cent and sometimes by as much as 30 per cent. This can appear very seductive. But what about the claim that there is too much money and not enough opportunity to put it to work? Deal sizes Much of the capital flowing into the industry has been into the large end (the mega buyout funds), which skews views of fundraising and the effects on the potential overhang. According to Private Equity Intelligence, over $47bn in buyout commitments closed in the first quarter of 2006. Fifty-five per cent of this was raised by funds greater than $5bn. These funds are expanding the industry upwards — focusing on larger deals than were considered before and opening up new capacity. Invest for the long-term Private equity is a long-term asset class – we do not believe investors should make long-term investment decisions based on short-term factors. A single private equity fund may experience a number of trends during its lifecycle. Trying to time investments into private equity to coincide with trends is difficult to accomplish. But private equity can benefit portfolios and as a result, the best approach to building a private equity investment is by making steady commitments to a diversified portfolio over successive years, avoiding over-commitment when the markets appear ‘hot’ and under-commitment during periods of economic uncertainty.
