'High risk' and 'speculative' are some of the attributes you might associate with private equity investing, but 'cautious' and 'naturally conservative' probably don't spring to mind. Yet this is exactly how Graphite Enterprise (GPE), an investment trust focused on private equity, describes its method of investing, a method which has also paid off in terms of returns (read our tip).
Private equity is investment directly into private companies that are not listed on a stock exchange, with the aim of seeking high returns on capital. So how is it possible to marry private equity with cautious, and naturally conservative portfolio and balance sheet management?
"Firstly, balance sheet management," says Tim Spence, finance director at Graphite Enterprise. "We don't want to put the balance sheet under undue risk and pressure, so over the last 20 years we have typically had a positive cash position. We have a bank facility which we recently increased to £100m but don't plan to draw on it on a long-term basis, and haven't drawn it yet. It is to make provision if we don't have cash for a short-term need."
In times of crisis such as 2008, concerned that the ability to sell on investments might totally dry up, the team at Graphite disposed of some assets and significantly reduced commitments, leaving them with more than 40 per cent of their assets in cash. "This was very different to our peer groups," explains Mr Spence.
This paid off with Graphite Enterprise's net asset value (NAV) falling less than 12 per cent in 2008 in contrast to its peer group average, which was down 24.46 per cent.
Another key way to maintain caution is portfolio construction. The investment team at Graphite avoid venture capital and risky, early-stage companies, preferring buyouts of mature and profitable companies. "Most buyouts are not about putting money in but change of ownership," says Mr Spence. "We prefer to buy companies that are trading well so that our investment is not growth capital."
Emma Osborne
They seek established managers with a proven track record in what they are doing. "Emerging managements are in vogue and have some merit but on the whole we think there is no substitute for experience," says Ms Osborne. "We look at underlying individuals and wouldn't invest with a very established company if there was churn in the team."
So knowing who the right managers are is key.
"There are around 500 managers in Europe but we wouldn't be interested in many of these," she continues. "There are around 120 who could potentially fit our portfolio today or in the future - we have contact with all of these. We do this so we know who is coming to market because the best funds don't need to advertise they are raising money. If you wait for the ones which make contact with you, you tend to have a lower-quality portfolio. The best managers don't come knocking on the door."
Once they have a target list in place due diligence includes looking at things such as managers' historical record and also the unrealised portfolios as historical performance may not be an indicator of portfolios put together over the last cycle. "This involves lots of reference checking, for example talking to people the management team worked with, which helps us build up a picture," says Ms Osborne.
Caution is also achieved by not having too much single company concentration - something easier done with a fund of funds approach. Most of Graphite's investments are in funds, typically established, top-performing European buyout managers. Around 23 per cent of its assets are in direct investments, mainly UK mid-market.
The portfolio has exposure to 336 companies in total.
Too late?
Private equity investment trusts have had a good run recently, with discounts to NAV tightening. Graphite's average discount since December 2007 had been 33 per cent, although today it stands at around 21 per cent. However, Mr Spence does not think that investors have missed the boat.
"The long-term average discount in the 15 years prior to the financial crisis was 10 per cent, and discounts could go tighter," he says. "That said, discounts on private equity investment trusts don't need to go tighter for investors to make money."
And now is a good time to make investments, argues Ms Osborne. Fundraisings are picking up, which gives them a wide range of investments to choose from and Graphite has cash to invest, so they expect to increase commitments significantly in the coming year. They will also continue to review opportunities to acquire secondary fund interests and co-investments as these would allow them to reinvest proceeds from exits more quickly.
The trust has around 12 per cent of its assets in cash, about £55m, as well as its undrawn bank facility, in contrast to many private equity fund investors who remain capital constrained. Graphite says a scarcity of capital tends to lengthen the time available for due diligence and to improve the terms for them, and when the underlying funds deploy their capital the pricing and terms should be more attractive, reflecting the lower level of competition.
New commitments will include an investment of at least £70m in Graphite Capital's next buyout fund.
"We're not assuming the economy will pick up but we don't need it to for good growth in our portfolio - we demonstrated this over the last four years," says Ms Osborne. "There are lots of global businesses in our portfolio and they can continue to grow regardless of the economy."
