Private equity investors face crisis of confidence

By Judith Smith, Head of Private Equity - 27 April 2011

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AUSTRALIAN private equity investors are experiencing a crisis of confidence.

As an investment activity, it is being overlooked for new allocations of capital by Australian superannuation funds for a number of reasons: investment management fees are considered too high, the investment is illiquid and the time frame for returns is long term.

Private equity is typically invested via pooled funds offered to investors by a specialised private equity manager. The funds have a defined investment period, typically five years, they are closed and the commitment, once made, cannot be altered.

Private equity management fees are higher than those of most other investment options, with the standard annual fee being around 2 per cent of the capital committed to be invested, and a performance fee of 20 per cent on the gains, once realised.

When contrasted to investors with listed equities, the annual fee is seen as high and the performance fee viewed as inappropriate (the value for money equation is not clear to many investors) in an environment where the management expense ratio is a large focus.

Too expensive, too complex, too inequitable and too illiquid are not issues easily overcome and the alternative, of investing in public markets to achieve equity exposure, is cheaper, easier and if you invest in larger companies, liquidity is available.

With all this to consider, does private equity have a place in return-focused portfolios?

Our view is that there is a compelling argument for private equity. True private equity investing is about building and transforming businesses that can contribute and play an important role to their communities.

Returns should be substantial, well in excess of public markets.

Private equity was always an activity dictated by opportunity and it emerged as an institutional asset class over the past couple of decades. With this positioning in the asset allocation matrix, larger funds have been raised investing in larger and larger companies carrying greater debt burdens.

Scale was created, large annuity fee streams derived by managers and alignment with investor returns became, at best, blurred.

Globally, private equity was in demand and we postulate that this style of investing became for some managers more about funds under management, delivering returns modestly in excess of listed markets.

This approach suits some large investors, but is this true private equity? We don't think so.

True private equity simply is not scalable, like listed markets.

Scale ultimately kills opportunity. The more money deployed, the larger the transactions, the more the industry looks like unlisted public equity. Managers focus on fund raising; they are no longer investment managers aligned to driving outstanding investment returns.

So what does true private equity look like?

The largest range of opportunities among unlisted companies is in the small and medium-sized enterprise sector -- that is, those with less than $500 million in enterprise value.

To successfully invest in these companies, a thoughtful and persistent approach is required to sift through the numerous opportunities and identify those businesses that meet the required criteria.

True, private equity investing is about what you buy, what you pay, what you do and what you ultimately build. Fees are higher generally than other investment classes because the activity is truly resource intensive, applied over a lengthy period of investment and the skill base is specialised and not readily available.

Investors in private equity need to consider costs and recognise that to generate returns, costs will be incurred. They need to know how to ensure those costs are wisely spent to drive value in the investment. Fees should be appropriate to resource a quality team to pursue outsized returns.

Outcomes must be aligned. What matters to you as the investor must matter as much to who you are partnering with.
Private equity investing is long term. New opportunities are pursued while existing investments are built or transformed, and those that have reached an appropriate value inflection point are exited.

It is a cycle that is repeated year in year out: building better companies over a time frame of three to seven years, delivering returns well in excess of listed market returns.

Private equity has played an important role in the capital markets available to Australian companies to support their growth and transformation.

However, available capital is diminishing as local investors retreat from the sector.

What does this mean for Australia?

First, it means private equity opportunities undertaken in Australia may be increasingly made by foreign capital.

Second, the nation's savings are becoming even more skewed to the local listed market and other offshore listed exchanges.

Third, it raises questions about how Australian capital markets build and transform businesses in the years to come.

Where does the capital come from to support new businesses?

Where are the new listed companies to be sourced from to meet the demand from listed investors?

How does corporate renewal and intervention happen?

What are the options for companies with complex issues that need skill, experience and capital to become stronger and have a more sustainable future?

If Australia's growing savings pool cannot contribute to this, then we become reliant on other sources of capital for this important aspect of capital-market efficiency.

No doubt some of this can be sourced from other domestic sources, wealthy individuals and offshore private equity investors, but not all of it.

The market for private equity has changed, and participants are responding to that change.

We believe there is a strong case for true private equity to be a part of investment portfolios, delivering strong net returns to investors, performing an important function in Australia's capital markets by building better companies and delivering for the economy overall.

Investors should be actively considering the question: is true private equity part of their portfolio strategy and, if so, is now the time to act?

This article appeared in the 27 April 2011 edition of The Australian.