The real deal

For retail investors, gaining access to the opaque world of private equity investment is possible via listed investment trusts and funds, which invest directly in unlisted companies or across a range of private equity funds. Many of those listed investment vehicles have traded on sizeable discounts to their net asset values since the financial crisis, when the asset class fell out of favour with investors. However, their popularity has risen since then, with the sector discount narrowing to an average 16.4 per cent last year, compared with 60 per cent in 2009, according to data from the Association of Investment Companies.

Yet with record amounts of cash flooding into the asset class, competition for quality investments is also rising. The question is whether private equity fund managers are at risk of over-paying for assets or if investors can still gain access to private investments that stand a chance of generating sufficient returns to compensate for the illiquidity and higher risks associated with the asset class.

The private members club

Private equity investment has proliferated in modern consumer life, from Terra Firma-owned cinema chain Odeon to Carlyle-backed breakdown services provider RAC. Yet the vagaries of how deals are structured and assets valued can be relatively opaque, in an investment environment that has high barriers to entry. Private equity firms – otherwise known as a general partner (GP) – raise money typically from institutional investors, pension funds or high net-worth individuals, known as limited partners (LP). That capital is then used by the GPs to take controlling stakes in companies, with the aim of improving the company’s capital structure and efficiency to exit the investment, via IPO or a secondary sale.

Given the minimum capital commitments are typically upwards of $10m, accessing these funds directly can be beyond the reach of many retail investors. That’s where listed investment trusts come in. They are typically run as fund of funds, investing in a range of private equity funds and paying them management fees to make investment decisions, but also sometimes invest directly in the unlisted company. The former can provide greater diversification geographically, as well as by investment vintage and manager strategy.

However, there are also a few UK-listed groups that invest directly in unlisted companies, notably recently listed venture capital specialist Draper Esprit (GROW). The shares have proven popular with investors, rising almost 80 per cent during the past 12 months. The group specialises in investing in high-growth technology companies in Europe, around 70 per cent of which are later stage, says chief executive Simon Cook. In identifying companies with high-growth potential, management looks for those typically posting annual adjusted cash profit growth of between 30 and 40 per cent and values potential investments based on the rate of sales growth compared to industry averages. Management is “very much activist” in its approach to the companies it invests in, sometimes sitting on management boards, as well as holding preference shares and veto rights, Mr Cook says.

Searching for value 

Historically low interest rates have not only reduced the price of debt, boosting the ability of private equity firms to increase the leverage of their portfolio companies (see boxout), but have also forced institutional investors to search for potentially higher yielding assets. Last year ‘dry powder’, the amount of uncalled capital, hit a record high of $1.7trn after steadily rising since 2012, according to data provider Preqin. 

A rise in capital raised is not necessarily a negative thing for the investment case of private equity, provided there is sufficient supply of assets to deploy cash raised. However, if increased competition for assets with sovereign wealth funds and other merger-seeking companies, as well as other private equity firms, drives up the price paid for investments, that could erode the potential returns passed down to general partners and their clients. In assessing the potential returns that may be generated by an investment, entry multiples are one of the best indicators. Those multiples are rising. Last year the average European private equity M&A valuation rose to 7.6 times adjusted cash profits, according to industry data provider Pitchbook, higher than an average of 5.3 times in 2007. That could eat into future returns. In the US, multiples have been rising even higher, reaching an average 10.5 times, compared with 8.9 times in 2007. 

“A lot of money has been raised at the mega-cap end of the market, where pricing has been higher,” says Aberdeen Standard Investments’ head of private markets product strategy and solutions Roger Pim. He reckons there are still opportunities in the small and mid-cap space. Indeed, the proportion of higher value deals completing is rising, with 59 per cent of all European capital deployed in deals worth over €500m last year, according to Pitchbook, up from 40 per cent in 2013. 

Assessing the performance of underlying private equity investments is tough enough, in comparison with publicly listed companies with daily pricing updates. The LPX 50, which represents the returns of the biggest 50 private equity companies globally, has outperformed the MSCI World since 2014. However, the key metric used by private equity firms to report their performance is the internal rate of return (IRR), the net return earned by investors over a certain period, calculated on the basis of cash flows to and from investors, after the deduction of all fees, including carried interest. However, some have become concerned that the use of bridge financing to initially fund investments is inflating returns, by shortening the time investors’ cash is put to work.

Associate Professor in Finance at Oxford University’s Said Business School Ludovic Phalippou, who has carried out numerous studies of the private equity market, also reckons the use of IRR to measure performance is “misleading”. “It can be manipulated by choosing the timings of cashflows,” he says. He thinks the net present value of an investment – which admittedly doesn’t take in future value creation – or the public market equivalent (PME) are better measures of performance. Under PME, every capital contribution and distribution of the private equity investment is matched by an equal and timely investment and sale of the reference benchmark, respectively. EP

Buyouts face competition but specialists offer an inside track to profits

Financing buyouts has been by far the most popular activity undertaken by private equity firms in recent years. The annual industry report by Bain & Company showed that buyouts accounted for $440bn of PE investments in 2017 – a 19 per cent increase year-on-year. Spectacular growth in the aggregate value of deals is down to some larger scale investments, especially in North America, rather than the volume of deals, which rose by a modest2 per cent, to 3,077. This again raises questions about the multiples being paid and the sheer level of competition between PE firms for the most attractive opportunities. Undeniably, funds are piling up a lot of dry powder – Bain & Company estimate $516bn un-invested capital for buyout funds alone – waiting for the right openings at reasonable valuations. Even in this sellers’ market, however, there are still PE firms that know how to spot and exploit further niches for their investors.

Private equity is an opaque asset class compared to publicly listed securities and the industry has struggled to shake off the corporate raider image of Gordon Gekko in Wall Street (1987). Far from being all about hostile takeovers and asset-stripping, however, private equity often helps promising companies reach a new level of scale, funding capex and advertising to grow businesses. While the level of visibility end-investors have in PE funds’ holdings is low, the opposite is true for PE managers and the companies they invest in. Steven Tredget, who is a partner at PE firm Oakley Capital, describes the level of knowledge private equity managers have about the private companies they buy as “being so extensive, they would classify as insiders if they were publicly-listed”. 

Buyout activity might constitute providing funding for management buy-outs, buying a spin-off division from another company, or taking a large interest in expanding entrepreneur businesses. In each situation, the high level of disclosure PE managers receive from companies helps enormously in picking the right investments for their portfolio. Mr Tredget says the level of due diligence is on another level compared to funds of listed equities. The PE investment process includes extensive examination of operational, industry-specific and key-person risks. It is also common practice for PE firms to have board representation, so they have much more say in matters of business strategy, decisions on the level of gearing and whether companies reinvest all profits or pay dividends.

Along with size and the maturity of business models, the trade-off in terms of risk is the more variable levels of liquidity for private equity holdings. Businesses may prove difficult to grow and sell, especially in an economic downturn, so there are periods when managers can’t dispose of assets profitably and realise returns for investors. This isn’t an issue right now for the sell-side of the industry; buyers awash with capital are queuing up for good businesses. The problem could come further down the line, with some funds re-investing profits and new capital over a longer time horizon, thanks to the shortage of good and relatively mature private companies available.

Reducing the maturity profile of investments could have a negative impact on quality, with more early stage businesses likely to fail in the next economic downturn – so investors need to understand how private equity funds are meeting the challenges of finding attractive companies. The task is made harder by competition from sovereign wealth funds and corporations, who are exploiting their very cheap cost of capital to snap up earnings-accretive and technologically strategic (i.e. patents) acquisitions. Specialisation is key for private equity firms. For example, Oakley Capital (whose investment trust Oakley Capital Investments (OCI) has been a Simon Thompson recommendation) has a strong focus on education, TMT and digital consumer businesses. Operating in the middle-sized market, primarily in Western Europe, they also say that competition from corporations is less of an issue for them, as only other PE firms can match the speed of getting deals through.

As well as being active in buying companies directly, private equity groups may also lend capital to leveraged buyout vehicles. LBVs are usually financed by syndicates which may include banks, PE firms and hedge funds. The LBVs then issue high-yield bonds to these investors. This type of financing arrangement is useful as the LBV can quickly raise capital from other institutions to acquire a controlling stake in a target company’s equity. They aim to profit by disposing of non-core assets (the asset-stripping which holds negative connotations in the popular mindset) and/or managing the company to become operationally profitable and get it in lean shape to return to the public markets in a secondary float.

The leveraged buyout vehicle style of investing differs greatly from PE firms that provide capital to growth businesses or help fund bolt-on acquisitions for companies. The breadth of investment strategies employed in the buyout space alone highlights the PE industry as extremely heterogenous, making discerning fund selection even more important for investors. JN

Deal or no deal?

Private equity investment is only for those with a higher risk appetite and a longer-term investment horizon, while any exposure should only make up a small proportion of a retail investor’s portfolio. What’s more, as the table on page 25 indicates, charges are usually higher than those associated with more traditional asset classes, and funds of funds carry higher costs again because they involve more than one layer of fees. What’s more, while investment trusts offer a more liquid way to access unlisted companies, returns can still be lumpier given the inconsistent timings at which underlying investments are realised. The level of diversification provided by investing in private equity as part of a broader portfolio is also disputed by some. “It’s difficult to say why they are not correlated with the [companies] that are publicly listed,” Professor Phalippou says. He argues the same macro-economic factors that could negatively impact publicly listed companies in a downturn would also likely apply to their unlisted counterparts. 

In terms of assessing the performance of listed investment trusts, the valuation metrics available to investors are much more limited than for listed equities. One of the main measures of value is whether a trust is trading at a premium or discount to its net asset value (NAV) per share. However, it’s not quite that simple – as discussed, the level of gearing employed can alter the NAV. A better measure to assess value is by using a statistical measure known as a ‘Z score’, which produces a standardised score based on where a trust’s premium or discount to NAV sits compared to an historic range. A negative ‘Z score’ indicates a trust is cheap relative to its own historic standards, while a positive suggests the opposite. On that basis, we’ve included the top five best value private equity investment trusts in the table overleaf. However, investors can also consider an investment trust’s momentum by looking at share price performance in recent months. Share price gains indicate positive sentiment towards a trust, which some research suggests can be a sign of more to come. A widening discount implies market scepticism, while the opposite is true when the discount narrows. EP