Low investment returns in traditional asset classes have continued to make alternative assets, including private equity, an attractive option for those high net worth investors seeking yields. Paul Golden investigates whether the ultra wealthy and family offices are becoming increasingly disillusioned with private equity funds because of high costs and modest returns.
Private equity remains a core area of interest to many wealthy individuals despite concerns around levels
of uninvested cash and a paucity of attractive deals. But could this traditional interest be on the wane or are we just witnessing a change in investment preferences?
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Data from alternative asset industry intelligence provider Preqin reveals that the second quarter 2013 was the second strongest quarter for private equity-backed exits in terms of value since 2006, with $92bn generated worldwide.
Yet the aggregate value of private equity-backed buyout deals announced globally between April and June fell to $62bn from $86bn in the first three months of the year.
Private equity consultancy Bain & Company refers to an intensely competitive deal-making environment and an overhang of ageing assets waiting to be sold. But its latest global industry report also highlights positive factors such as a likely resurgence in corporate M&A activity and signs of a recovery in IPOs.
Alongside sovereign wealth funds, pension funds and educational endowments, family offices and high net worth individuals are a key private equity investor group. BCG’s 2012 global asset management survey refers to a shift in investor preferences towards alternative asset classes.
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By GlobalDataThese investors are looking for highly experienced partners with a strong focus on a specific market and a good track record according to Adley Bowden, PitchBook director of research.
Bowden says private equity firms have become better prepared and more savvy on the operating aspects of companies since the global financial crisis.
"They might appear to be more risk averse, but in reality it is about better understanding what the risks are. One notable trend has been to recruit operating executives to act like internal consultants in portfolio companies,"
he says.
Going direct
Ultra high net worth individuals (UHNWIs) and family offices that have large allocations to private equity tend to invest in direct limited partnership funds that are of 10 years duration with a minimum investment 10-20m and build up a portfolio of fund commitments, explains Alice Kain, head of investor relations Aberdeen SVG Private Equity.
"The next group down tend to go for fund of funds, which will give them exposure to perhaps 20 funds for a lower minimum investment, which can be up to 5m but as low as 1m, albeit with the same length of commitment. Many HNWIs tend to invest through the listed private equity market, where there is no minimum investment and good liquidity."
Many institutions tell clients to expect 5% outperformance of listed markets as a risk premium, but Kain acknowledges that there is a huge disparity in returns between top and bottom quartile funds.
"Manager selection is key, which is why family offices often outsource to a fund of funds manager. Investors can exit funds before they liquidate, but this is usually at a discount in the secondary market which is not a very efficient process, especially for smaller holdings.
"Tim Bell, head of alternative investments at UBS Wealth Management UK, observes that the starting point in terms of wealth for investors to be able to invest in private markets (which include asset classes other than equities that may benefit from an illiquid investment approach, such as debt and real assets) tends to be $5m owing to qualified purchaser and accredited investor rules.
"Wealth managers that are active in private markets tend to reduce the minimum investment amount to $250,000 for any investment. The reality therefore is that investors with $5-20m investable wealth need to ensure that their private equity investments are sufficiently diversified as they are slightly limited in terms of the number of individual investments that they can make, whereas the larger investor can afford to take a more granular approach to their
investment strategy."
Sticking to their knitting
Aside from earlier stage investments associated with venture capital, investors tend to favour themes or specific opportunities rather than specific industries, says Bell, who refers to an upsurge in interest.
"Since around the fourth quarter of 2012 we are seeing a high level of distributions coming back, with investors willing to re-commit to private markets investments."
Private markets covers a wide range of underlying asset classes. There is a degree of variation around the timeframe of these different investments and UBS is finding that very specific opportunities with a shorter duration have a particular appeal to those investors who are averse to the longer timeframe associated with private equity.
Bell advises investors to diversify their investments across multiple vintages (timings of entry and exit points) in order to reduce risk. He adds that while wealthy entrepreneurs tend to like direct investments and coinvestment or club deals, for more traditional private markets investments investors tend to rely upon the expertise of the general partner.
Kamran Anwar, Citi’s EMEA head of private equity services, refers to pockets of private capital going into private equity, looking at co-investments and becoming a private equity fund in their own right.
"Family office money tends to get directed towards areas with which the family is comfortable, whether that is an affinity with a certain brand or a specific industry that is a logical extension of the family’s business activity. The bias of the high net worth individual varies, although there is inherent comfort with some sectors, such as real estate."
He explains that the bulk of private equity capital still comes from North America, followed by Europe and that there are many family offices below the radar – particularly in the Middle East – which general partners don’t get to.
According to Anwar, the importance of periodic liquidity events and shorter duration of investment as well as a voice in the investment decision and increased information are all becoming essential components for investors who are more aware of risk exposure and are asking questions about their exposure to specific industries/regions.
"Investors are showing greater willingness to bypass intermediaries and make direct private equity investments. As the next generation take over the family wealth, their ability to be knowledgeable about private equity and other asset classes is greater and their willingness to play in the direct investment space is increased, although the merits of direct investment are counterbalanced by the tax transparency that a limited partner provides."
Inexperienced private equity investors sometimes fail to appreciate the growing gap between the good managers and the rest, suggests Olivier Palasi, head of private equity research at ABN AMRO Private Banking.
"They are focusing more on track record, which is essential, and less on the investment team. Investment teams often change, so you need to keep up to date with who is responsible for performing deals and where they are currently working," says Palasi.
MENA-based clients typically invest more in private equity than other ABN AMRO clients worldwide and are particularly interested in local/regional firms, he adds.
Part of the club
"Demand for direct investments, investment in partnerships or even in a fund of funds comes from across the client spectrum. For direct investment, the clients’ network is essential. Whether you are very rich or not, you are taking stakes in companies which necessarily involves a greater level of risk. Although private wealth manager clients
make investments in the venture space via club deals, these investors need to be aware that this is the most difficult type of private equity investment to get right – and that they can stand to lose their investments."
Palasi suggests that direct investment can be risky for investors who lack experience of taking stakes in businesses.
"Many ‘direct investors’ underestimate the sensitive step of negotiating a strong shareholders agreement, the monitoring of investments and the exiting process. If you don’t have time to be hands-on with your investments, it becomes uncertain in term of success."
There is considerable appetite for private equity given that yields on public markets are low and that investors already
have exposure to these markets, says Mohammad Syed, head of strategic solutions at Coutts.
"For high net worth individuals the fund market is probably the best route because of diversification and the ability to screen investments. But as you move up the scale of wealth it becomes increasingly apparent that clients want transparency and visibility on where their investments are and ultimately to make them directly. These investors are full of ideas and see opportunities – what they don’t have are teams that can help them assess these opportunities."
Return expectations depend on whether the investment is made in a developed or developing market. "Timeframes typically range from 5-10 years, but some companies with positive cash flow will do better to remain private and look at future dividends and ultra high net worth clients will not exclude this option," suggests Syed.
Outlook for Europe – Patchy
Steve Langton, vice president EMEA private equity business development State Street, observes that demand for private equity investment across Europe remains patchy, with established markets such as the UK, France and the Netherlands balanced by relative newcomers such as Germany.
"With some investor sources of capital drying up, I can see more private equity firms tapping the listed markets and making their products available to the wider retail/high net worth market. Investors generally take the general partner’s track record, level of returns and how these returns were produced in account, although there is a segment
that will only invest in general partners that have solid environmental, social and governance principles."
While track record is a very important component of analysing a fund, each new opportunity should ultimately be judged on its own merit according to Ignatius Fogarty, Preqin’s head of private equity products.
"Analysis of track record is a key component of an investor’s due diligence process. There is clear evidence to suggest that managers of top-tier funds are more likely than their peers to continue to produce top performing
funds in the future, though we must note that past performance is not a guarantee of future success."
