What next for private equity?

If you had bought shares in Standard Life European Private Equity Trust in mid-February 2009, you would be sitting on a gain of almost 170% a year later.

Even the average private equity investment company (PEIC) has seen an increase of more than 60%, almost three times the return on the quoted companies in the FTSE 100.

That is not because these vehicles have had a brilliant year – if anything, the opposite is true. The underlying performance of the assets in these trusts was far more pedestrian.

The best, Northern Investors, grew by just 17.7%, according to figures from Trustnet. The surge in private equity trust shares reflects relief that Armageddon appears to have been avoided.

That relief rally is over, however. Now, the industry faces the challenge of adapting its business model to the new financial climate and investors need to assess which PEICs will thrive and which will fall by the wayside.

A year ago, investors were worrying about everything from the collapse of the financial markets to a global depression; stockmarkets were at their lowest levels in five years; banks were wholly reliant on government support for their survival and property markets were moribund.

A broken business model?

Private equity was, if anything, in an even more parlous state: its entire business model appeared to be broken. Historically, private equity firms had made their money by backing small businesses and helping them to grow.

For much of the past decade, however, far more of their returns came from financial engineering: loading deals with cheap debt and making a quick turn, often through 'pass the parcel' deals among each other.

The financial crisis brought that to an abrupt end. The few banks that were still able and willing to lend were charging much more and lending much less. That made funding new deals all but impossible.

Getting money back from existing deals – 'realisations' – was harder still. The stockmarket was in no mood to back company flotations; trade buyers were too busy trying to cut costs and refinance their own debts to consider making acquisitions; and, as all private equity firms were in the same boat, the game of pass the parcel could no longer be played.

When the new money stopped

To make matters worse, many of these PEICs were committed to piling large sums into large buyout funds.

As well as doing their own deals, PEICs will often subscribe to funds run by private partnerships and some of them – Standard Life European Private Equity, SVG Capital and Candover were among those particularly affected – had commitments amounting to more than their total available cash.

That was fine while investors were still willing to put new money in and realisations were healthy; when that stopped, these commitments threatened their very existence.

That pushed the discount between the price of PEIC shares and the value of the underlying assets to record levels – at the lowest point, some were trading on discounts to net asset value (NAV) as high as 70%.

A year on, things look a bit brighter: banks are gradually starting to lend again, albeit in a limited way, the stockmarket has risen dramatically and flotations are once again being talked about as a possibility.

Most PEICs have also dealt with their over-commitments through a combination of sales of assets or negotiations with the buyout funds to renege on their liabilities. That has helped to narrow the discounts substantially although, at an average of 27%, discounts are still high.

But there are still significant challenges ahead. "Funding strategies have to change," says Brian Scoular, manager of Dunedin Enterprise Investment Trust.

While PEICs investing in a new company could previously have counted on raising debt equal to around four times the level of the company's earnings before tax, interest and depreciation (and the giant buyout firms who were buying businesses such as BAA or Boots could have raised eight times those levels), now banks will contemplate multiples of only around two.

They are charging significantly more – margins have risen from around 2% above Bank base rate to between 4% and 5% – and want their money back sooner.

That means more of the funding has to come from equity, rather than debt, says Scoular. "That has an impact on returns. It means we need to do more with the businesses we acquire."

That will bring business management skills, rather than financial ones, to the fore. Private equity firms will have to look for acquisitions where they can add value by, for example, helping them become more efficient, find new markets or improve their strategies.

It is back-to-basics – it is how private equity started out, when it was more commonly known as venture capital – but not all will be able to prosper in this new regime.

Peter McKellar, co-manager of the Standard Life vehicle, points out that there has always been a "high dispersion of returns" between PEICs.

The past year was a prime example, with the highly geared ordinary shares of Aberdeen Development Capital (it has a split capital structure) losing 27.5%, compared with Standard Life's 169% gain.

But that dispersion is equally true over long periods and in the performance of the trusts' assets as well as share prices.

"But there is also a high degree of consistence; good managers are good across the cycle," says McKellar. Standard Life European Private Equity is one of the more consistent, as is HgCapital – one of the favourite PEICs among financial advisers and one with an excellent record: it has returned an average of 11.6% a year for the past decade compared with a loss of 3.5% for the average PEIC, and its return over that period is 2.5 times better than its nearest competitor, Electra Private Equity (which recently restructured as a split capital vehicle).

Ian Armitage, chairman of HgCapital and of the Listed Private Equity Association, dismisses suggestions that the private equity model is broken.

"Private equity is in the business of financing change – of ownership, strategy, structure and so on. That is what it does best," he says, so it should be able to cope with change in its own industry.

Armitage adds that it has some key advantages over investors in public markets, including a strong alignment in the financial interests of the business managers and their investors: "They all get a share in the outcome of the business," he points out.

There is also a bigger universe of opportunities to invest in, including private and family-run businesses; the ability to control the timing and method of sale of the whole company to maximise sale proceeds; and the ability to remove underperforming management teams more quickly and easily than investors in public companies can.

But he admits that the industry will shrink – consultants such as Bain & Co have predicted capacity will fall by as much as 40% as unsuccessful managers simply fail to attract new money. HgCapital has just raised £1.8 billion in new funds so has plenty of scope to invest.

Restructuring opportunities

The amount of cash a Peit holds is likely to be key to its long-term performance: those which invested heavily in the frothy years of the mid-1990s, and failed to sell while the market was buoyant, are likely to struggle.

Others such as Dunedin Enterprise or Hg, with substantial sums available to invest, should be able to take advantage of current opportunities at more realistic prices. But Scoular says that prices still have a bit further to fall: "Prices for good quality assets are still high."

Nor are there many deals around, although Armitage expects the flow to increase this year, and in 2010 and 2011: "Banks will eventually sell the assets they are holding.

"And, in the upturn, there will be more restructurings as companies which are financially stretched will have to sell parts of their business – for example, we bought a business from AIG [the failed American insurer] in Spain, and BAA's sale of Gatwick was as much to do with its leverage as with competition issues."

Time to buy in?

Ben Yearsley, investment manager at financial advisers Hargreaves Lansdown, says that recessions have traditionally been the best time to buy into private equity: those who bought in 1990 or 1991 did very well.

Certainly, the current discounts are attractive – albeit that the discounts partly reflect the prospect of further write-offs on some of the assets in the trust.

And Stephen Cavell, a senior partner with Graphite Capital, points out that private equity deals done after the recession in the early 1990s had "little or no bank debt yet there were very good returns to be had.

"The missing elements at the moment are deal volumes and acceptable pricing. We firmly believe both will come," he says.

But investors need to ensure they pick trusts able to cope both with the changed conditions in private equity, and take advantage of the current depressed market.

Oriel Securities points out that industry giant 3i has not made any acquisitions for 14 months which "is likely to have some implications for the realisation profile of the funds in three to five years time".

HgCapital has one of the best long-term records and deserves a place in an investor's portfolio. Analysts at Oriel Securities also tip Candover, Standard Life European Private Equity and the highly geared ordinary shares of Electra Private Equity.

But anyone contemplating buying should be aware that private equity is a long-term investment and be prepared to hold for at least five years.

What do private equity firms do

While their aim is to make gains by investing in growing businesses, there are a number of ways in which they can do this. The traditional route was through a management buy-out, where the bosses of a company or a subsidiary of a company acquires the business.

The managers and the private equity firm will usually take a sizable proportion of the equity, but most of the deal will be financed with debt.

Gradually, however, debt became so cheap and so freely available, and stockmarkets so buoyant, that it became a key part of the deal and leveraged buy-outs were born.

Firms such as Blackstone, KKR and Permeira launched leveraged buy-out offers for businesses like BAA, Boots and Debenhams, with debt of as much as eight or even 10 times the earnings of the target company.

The aim was to pay off the debt, partly through trading but also by selling the business for substantially more than was paid, giving the equity holders big profits. Often, the buyers ended up being other private equity houses, keen to invest their huge funds.

Most of the smaller quoted private equity trusts confine themselves to smaller deals and were not involved in the kind of mega leveraged buy-out deals, many of which are now running into problems. But they do often invest in buy-out funds run by bigger players.

This article was originally published in MoneyObserver- Moneywise's sister publication - in April 2010

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