Global Investments

We examined research done by the Finance Department at the University of Basel, which concluded that the “listed and unlisted private equity perform in an almost equal way”.  After carrying out our own analysis and investigations, we came to same conclusion.  Listed Private Equity also has several advantages over unlisted, the most important being liquidity and no or mitigated J-curves.

For a long time the traditional investors in private equity were defined benefit funds or endowments with long-term investment horizons.  Nowadays most new pension funds are structured as defined contribution funds with greater liquidity needs.  Private equity managers recognizing this need for greater liquidity are responding by launching listed funds.  There are also other investors such as retail investors, multi-managers and fund of funds which prefer listed funds.

The sector is evolving rapidly.  The most recent trend has been the listing of a number of traditionally-structured private equity limited partnerships.  This may well be a “best of all worlds” solution in the sense it takes the traditional unlisted private equity partnership structure (i.e. the closed-ended, single use of capital, terminating life structure that winds down as capital and profits are returned to investors) but simply lists it on a stock exchange.

But perhaps the biggest trend has been the development of Listed Private Equity funds by established managers which simply invest alongside other institutional investors in the manager’s unlisted limited partnerships.  Hg Capital is an example.  If you buy Hg Capital Trust plc (their listed vehicle) you get an exposure to many of their existing unlisted funds, and when they launch their next fund, the listed vehicle will make a commitment to the new fund.

Another trend is the listing of private equity management companies “stapled” to a balance sheet of investments made by the manager.  Recent examples are global brand name managers such as KKR, Blackstone,  Carlyle, Oaktree Capital and Apollo.

There are over 300 Listed Private Equity entities (LPEs).  We screen this universe down to about 100 on the basis of key criteria, such as minimum requirements concerning liquidity, market capitalisation, governance standards and fee terms.

We then rank the remaining 100 or so securities according to two sets of criteria.  The first set relates to the quality of the manager and the manager’s ability to create value.  The second relates to the LPE’s investments and their return potential.

The top ranking 40 or so stocks are modeled and researched in depth.  For each stock we seek to project returns (Net Asset Value growth plus distributions) and the potential for any share price discount to NAV to close.

Based on the outcomes from this exercise we aim to construct a portfolio of the 15 to 25 highest return potential LPEs.  We seek to construct a portfolio that is sensibly balanced across the different deal stages of venture capital, small and large buyouts, growth capital, mezzanine debt, distressed investments and secondary investments.

We believe that the sector is very poorly researched and very poorly understood.  Most of the broking firms and other research houses tend to analyse Listed Private Equity funds as they do listed investment companies.  They tend to use a fairly superficial discount to NAV or dividend yield-type approach.  Our investigation goes a lot deeper.  As well as evaluating a private equity manager’s “franchise” and ability to create value, we value Listed Private Equity funds bottom-up, company by company.  Where we can, we model each company in a funds’ portfolio and project the likely NAV growth.  By talking to and meeting with the private equity managers themselves and other industry participants, we believe we get an “edge” over the market and can identify those stocks that are going to deliver the highest returns.

In evaluating a manager we look for evidence that they have an ability to repeatedly create value.  We investigate all aspects of their investment track record.  Our investigation includes analysing their returns, their ability to source and originate transactions, their ability to exit deals, their ability to create value at an operational level.

Amongst other things, we evaluate the team including the skill sets and experience of the different team members, the leadership of the team and team dynamics, the remuneration structures, and their alignment with investors’ interests.

In evaluating an LPE structure we consider things such as the management arrangements.  Is the management of the fund external or internal?  What are the terms of the management contract?  Is there good alignment with investors’ interests?  What are the governance arrangements?  How well managed is the vehicle in terms of reporting and transparency, capital management, and distribution policy?

Although we don’t have hard and fast rules, we typically prefer LPE structures where the fund is internally managed.  Often this means that the fees paid by investors at the LPE level are defrayed by fees paid to the managers by third party investors in their other funds.

Discounts obviously vary through the economic cycle.  Their longer term average is approximately 10%, but during the peak of the financial crisis in 2009 we saw these discounts grow to 50%.  Discounts are affected by many things: liquidity, distribution policy, transparency and market sentiment factors.  Discounts tend to close though when the market has good visibility on underlying NAV growth.

Traditionally the LPE sector has been more volatile than we think the fundamentals merit.  For example, during the onset of the financial crisis from 2008, the sector was sold down aggressively on general fears of “leverage” and re-financing risks.  These fears turned out to be exaggerated.  In general, private-equity backed companies have fared very well in the subsequent period with the failure rate of private equity companies being much lower than for the market in general.

Notwithstanding that, the price of LPEs can be quite volatile and higher than broader market volatility.  It’s probably true that higher volatility is likely to be a permanent feature of the sector.

As discussed above, market sentiment factors drive stocks to discounts that are higher than are justified by fundamentals, so this higher volatility can provide opportunities to acquire LPEs at very attractive prices.  Conversely, it can also provide opportunities to sell at inflated prices.

The importance of liquidity depends on an investors’ time frame. Defined benefit plans and endowments typically have much longer time horizons and lower liquidity needs than most other investors.

For large pension fund investors with an established private equity program in unlisted private equity partnerships, LPE can complement the overall portfolio. There are some very large pension fund portfolios that invest across primary funds, secondary funds and LPE and at any point in time allocate towards the sector they believe offers the best value.

For private investors, multi-manager portfolios, fund of fund portfolios and perhaps defined contribution funds that require daily liquidity, LPE can provide an exposure to private equity with daily liquidity.

Barwon has some large institutional pension funds that take a more opportunistic approach to investing in LPE.  These funds have established private equity programs and they tend to invest when LPE looks cheap relative to investing in unlisted funds available on the secondary market, for example.

We have multi-manager or fund of fund clients who have made a strategic allocation to private equity but require daily liquidity.

We also have a growing number of private individuals who are investing through their self-managed superannuation funds.  Typically these investors don’t have the scale nor the sufficiently long investment horizon to invest in traditional forms of private equity.  Hence they favour Listed Private Equity investing via a globally diversified fund.