Following the publication of the FTfm article, ‘Sceptical investors taking the more direct route’ (July 11 2010), discussions in the press have focused on the private equity fund of funds sector and the idea that pension funds will shift from investing via these vehicles to a more consultant-led or direct investment model.
Historically, pension funds have used a mix of strategies to deploy their private equity allocation depending on their own size and experience in the asset class. We agree that some of the largest pension funds and sovereign wealth funds have their own direct private equity strategies to deploy capital that involve a mix of direct and fund investments.
However, we are convinced the majority of global pension funds remain open to the idea that the additional layer of fees charged by private equity fund of funds represents a price worth paying to get the requisite access and the assurance over administration and compliance that an experienced manager can bring. Our pension fund clients engage us to provide a complete private equity solution for what is typically only ever up to 5 per cent of their total investment portfolio.
The majority of pension funds do not have the €100m (£83m, $132m) allocation to private equity that has been noted as the level that would allow them to invest directly in a structured long-term way into private equity. For these schemes, the hurdles of minimum allocation, administration of the investments and the risk diversification mean that a fund of funds is the only viable route.
In SL Capital’s fund of funds, the average commitment by a client is €12m, which would normally represent the pension fund’s entire private equity commitment, or at least its entire US or European private equity commitment. It is impossible to get true diversification, across at least 10 private equity funds, with a €12m allocation, as most funds require a minimum commitment of €5m.
It is also worth noting that the larger funds of funds sit on the private equity funds’ advisory boards as a matter of course. These positions are open only to the largest or most sophisticated investors and offer a deeper access and relationship to the manager, enabling added insight, a view on strategic direction and a first look at valuations and performance. This really matters when times are difficult, as the experienced fund of funds investors can deploy their team’s deep knowledge and expertise to help restore confidence in leadership or offer solutions to ensure all investors are protected.
While the world’s largest pension funds operate significant teams globally, we as a fund of funds also work closely with them to deploy capital. In this case we are providing support in a specific area of the European or US markets that they find hard to access, due to their proximity to the market or knowledge of the best managers in that segment. In these terms we are the “eyes and ears” for these larger groups in specific areas, such as smaller, regional or local funds, secondaries and direct co-investments. They recognise the advantages of working with fund of funds that can add value to their overall programme.
PE funds and funds of funds got hit hard during the crisis, but there is evidence that PE is finally turning the corner. Tom Fairless of of Financial News reports, Private equity emerging from the deep:
In July 2007, Charles “Chuck” Prince, then chief executive of Citigroup, said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
It is exactly three years since the music stopped. On August 9, 2007, BNP Paribas said it had suspended three funds linked to US sub-prime mortgages because it could not value the underlying assets. Within hours, the London interbank offered rate soared to its highest level in six years, forcing the European Central Bank to promise unlimited cash to keep credit flowing.
Thus a French bank called the end of a debt binge rooted in the Anglo-Saxon world that ultimately engulfed the global economy. The era of mega-buyouts – which culminated in the $45bn acquisition of US energy group TXU by a private equity trio in February 2007 – ended abruptly. An agreed $52bn buyout of Canadian telecoms group BCE fell apart the following year.
Six of Europe’s top private equity executives reflect on the impact of the credit crunch, and whether the industry will return to its pre-crisis heights. They responded to the following questions:
1) How significant is the financial crisis in the history of private equity?
Michael Queen, chief executive, 3i Group: In my 25 years in private equity, I believe we’ve seen the most challenging market since the industry emerged in the 1980s, with a significant decline in investment and a very tough environment for fundraising. While there’s cause for some optimism, I think we’ll continue to see challenging and volatile markets for some time.
Dominique Senequier, chairman and chief executive, Axa Private Equity: Private equity has a longer history than people think. We have been rocked by many crises. The most recent, post-Lehman crisis has been like a meteorite hitting the earth. But what it has shown is that the industry has the capability and strength to adapt, redefine itself and continue forward.
Andrew Joy, partner, Cinven: This is the first big crisis since the industry came of age, and as a result will stick in all personal and institutional memories. In the long run, the recent crisis will be seen as a healthy corrective to the increasingly spreadsheet-driven, unreflective habits that were spreading in the industry and its service providers.
Jeremy Coller, founder, Coller Capital: Private equity is a young industry and the financial crisis is the biggest single event in its history. I think, with hindsight, it will come to be seen as an important milestone in private equity’s evolution as an investment discipline and an asset class. The lessons learnt by fund managers and investors alike will guide the development of the industry for many years to come.
Johannes Huth, head of Europe, Kohlberg Kravis Roberts: One year ago, investors were assessing the impact of the financial crisis and sought liquidity wherever available. Today, as investor confidence is returning, we see increased interest in long-term asset classes, such as private equity.
Kurt Björklund, Co-managing partner, Permira: Clearly it was very significant. Investment activity collapsed; some portfolio companies came under great pressure; the financing environment was thrown into reverse; and it impacted the dynamics between limited and general partners. But the industry has shown throughout a number of cycles that its model works as well in defence as in offence.
2) Where are the biggest post–crisis opportunities?
Michael Queen: We see opportunities in infrastructure around the world where demand remains strong, as well as mid-market and growth deals as companies continue to struggle to access funding. Geographically we’re seeing some recovery in Asia and resilience in emerging markets although this tends to be reflected in pricing.
Dominique Senequier: There are many. But the two I would highlight would be firstly that the crisis provides an opportunity for the industry to show it can be a real contributor to growth and prosperity in society. Secondly, it has demonstrated that private equity can be a source of capital outside the equity markets.
Andrew Joy: Strong businesses with growth ambitions will need long-term, committed shareholders with the skills to help. Public markets have been shown to be fickle so private equity is in pole position to develop such companies.
Jeremy Coller: There are many opportunities: in secondaries, financial institutions need to restructure to meet changing regulatory requirements and many investors will want to reshape their portfolios in the face of new economic realities. More generally, private equity has a big opportunity to demonstrate its added value to the economy and society, by helping rebuild companies and their infrastructure.
Johannes Huth: We see an investor base that is particularly focused on opportunities in faster-growing economic regions, in natural resources and infrastructure and in investment opportunities across the capital structure of companies with growth potential.
Kurt Björklund: Private equity thrives on dislocation and rapid change. Firms with strong sector experience and geographical presence are able to generate high-quality opportunities from a range of different sources, many off-market in today’s environment. Balance sheet repair, for financial and non-financial vendors alike, is providing strong dealflow at the moment.
3) Will the industry be smaller or larger in five years?
Michael Queen: It is hard to say at this point, but there is no doubt that the private equity industry will have changed as a result. We’ve already seen some fallout during the crisis and stronger diversification of investment strategies. We could see newer entrants including sovereign wealth funds enter the fray.
Dominique Senequier: It will be larger in assets and probably in terms of players and stakeholders. But at the international level, the key opportunities for pension funds will only be those presented by private equity firms that have global reach and capability.
Andrew Joy: The industry is likely to be larger. I believe that private equity has intrinsic advantages over public equity, including a longer-term investment horizon, alignment of interest between management and shareholders and engagement by the owners in helping growth.
Jeremy Coller: The size of the industry is relatively unimportant; what is important is that it will be more robust.
Johannes Huth: We expect to see a limited number of large firms with a global network, which can offer partnerships with investors and companies on different types of investment opportunities. On the other side, we also anticipate a large group of small firms that operate on a regional level and specialise in specific opportunities.
Kurt Björklund: The industry’s long-term growth trend will continue but, inevitably after the recent period of very rapid growth, we expect to see a period of limited growth over the short term.
4) What is the biggest lesson you have learnt from the crisis?
Michael Queen: At the top of the market it is easy to forget that a long-term successful business is built on values, relationships and an ethical business model – the downturn helps everyone to remember these enduring truths.
Dominique Senequier: Stick to your convictions. We did. We distanced ourselves from the deal-making frenzy in 2007; we remained focused on not over-indulging in financial leverage, but instead found ways to support good management teams. It doesn’t always make you “flavour of the month” but such an approach rewards a disciplined, long-term investment philosophy.
Andrew Joy: The biggest lesson is to remember the previous lessons! To anyone who was in private equity in the late 1980s nothing that happened in 2007-08 should have come as a surprise. Likewise, none of us should be surprised if the years 2011-13 turn out to be excellent years for making investments.
Johannes Huth: The crisis has strengthened our belief in how important it is, from a value creation and a societal point of view, to stand shoulder to shoulder with our portfolio companies and investment partners, especially in challenging economic times.
Kurt Björklund: That early recognition of a changed environment, early and decisive action as opposed to debate, and a strong senior team pulling in the same direction makes all the difference. Also that you have to keep a very open line of communications throughout the organisation and with your investors in good and more difficult times.
These are all excellent points, but the biggest reason PE has turned the corner is that confidence has flowed back in public markets and larger investors are willing to take on more long-term investments in private markets. There remains one big structural impediment to PE, namely, banks are unwilling to lend ridiculous amounts to mega buyout funds as they did during the boom years, but this is all for the better.
We are moving into a leaner and meaner environment. Long gone are the days of "sophisticated" financial engineering and crazy leverage. Fund managers with operational experience are going to survive the shakeout in the PE industry while the quants and their spreadsheets are going to be left in the dust. PE is a tough business. Only the strong survive.