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Invest with a clear mind06/08/2001. Source: Bacon & Woodrow. Kerrin Rosenberg 
Confused about private equity? You wouldn't be alone. Kerrin Rosenberg of Bacon & Woodrow dispels a few myths about this rapidly developing asset class and explains why pension funds should at least consider investing in it. Many investors are simply confused about private equity. Hardly surprising given that they have probably been the victims of scores of hard-sell attempts and that transparent, industry-accepted data is nothing like the quality they are used to for quoted investment.
With this in mind, I'd like to debunk some commonly held misconceptions about private equity.
First, private equity does not provide diversification from the risks of quoted equity markets. Remember that private equity managers often exit their investments either by floating them on stock markets or by selling them to quoted companies. Either way, the exit price will be very much affected by the level of the stock market.
Aha, say the hard sell salesmen, but private equity returns show low correlations with quoted equities, and the historical volatility of private equity is quite low. Private equity investments did not fall as much as quoted stocks during the latest tech shake out.
But that's not surprising either. Private equity valuations exist only in the minds of the fund managers. During the recent tech crash, most private equity valuations did not reflect the prices that could have been obtained had the investments actually been sold. The so-called low volatility of private equity could easily be replicated in a quoted portfolio, by asking the fund manager to value the investments using imaginary, smoothed values until they are actually sold.
Yet there is one sense in which private equity does provide diversification. The more you spread your portfolio between different types of equities, the less exposure you have to any one stock, industry, region or other segment of the market. In this sense, allocating part of the equity portfolio to private equity does diversify risk. But, make no mistake, it still provides equity exposure.
Another misconception is that private equity is only appropriate for a small number of well funded, immature pension funds. It's true that private equity carries greater risk than quoted equity. But investors should remember that by far the most significant risk decision they take concerns the size of the overall equity allocation. Most UK pension funds choose to invest between 50 per cent and 80 per cent of their assets in equities. It's at this level that consideration should be given to the plan's funding strength, maturity and strength of the employer's covenant. Once the overall equity weighting has been set, the additional risk in moving, say, five per cent of total assets from quoted to private equities is not that significant.
So, why else should institutional investors take private equity seriously? Quite simply because it offers the potential for higher returns than quoted stock markets. And this provides a strong clue as to how the private equity portfolio's performance should be benchmarked. You should only invest in private equity if you believe that you can identify and access managers that are likely to outperform quoted equity markets over the long-term. You clearly also need to be comfortable about the additional risks you would bear.
The performance statistics of most interest to investors ought to be how the private equity portfolio has performed (net of all fees and costs) compared with an investment in quoted equity returns. This is easier said than done. Most quoted equity returns - be they index returns or returns for actively managed portfolios - are simply not comparable with the internal rates of return that are usually calculated for private equity investments. The former does not take account of the timing of investor cash flows, whereas the latter does.
The difference between the two approaches is pretty large. Consider the case where the stock market halves during the first six months of the year, but doubles during the second half. Over the year, the market has produced a flat return of 0 per cent. However, if an investor had put £50 into the market on day one, and £50 after six months, his portfolio would have been worth £150 at the end of the year.
The solution is called the Public Market Equivalent (PME). The calculation is simple in principle, but is not commonly used in Europe, and it is not regularly quoted in the BVCA or EVCA performance statistics.
The PME shows the return that would have been achieved had you invested the same cash flows that the private equity fund generated in an index-tracking fund. It is essentially an index return, adjusted to reflect the timing of cash flows actually experienced in the private equity fund. PMEs are regularly used in the US, and I would encourage all investors to monitor their private equity programme against this benchmark.
The other often-cited disadvantages of private equity are illiquidity, long-term commitment, valuation difficulties, performance measurement problems and high costs. These are all valid points and investors should certainly understand the investment characteristics of private equity before making a commitment. However, all of these points can be answered, and it is our view that they should not be the main factors that determine whether a fund invests in private equity or not.
The key factor is whether the investor has confidence in his ability to identify and access above average private equity funds, because manager selection and access is far more important in private equity than quoted equities.
In our view, the private equity market has matured sufficiently to warrant serious consideration by pension funds. But it's probably also fair to say that most European pension funds are in need of significant education on this area before being in a position to make an investment.
© Bacon & Woodrow 2001
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