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Diversification

Much debate surrounds the issue of diversification within a private equity portfolio. Here, Bruno Raschle of Adveq Management outlines recent issues surrounding diversification and suggests ways in which investors may have to change their strategies in the coming years.

Diversification within a private equity portfolio is an issue that generates a lot of debate. Should private equity investors diversify these portfolios or not? Not everyone believes in diversification, but those that do say it is essential, given the long-term commitment that must be made to private equity investments.

Sectoral and geographic diversification are important provided the strategy used takes into account risk parameters likely to arise in the future. Even so, if you have the opportunity to associate with an outstanding investment manager, who has a structured approach for leading an industry sector into the future, I believe this opportunity could override any sectoral diversification considerations.

Historically, those institutional investors that have diversified their private equity portfolio have done so according to criteria such as vintage year, geography, stage, investment size, or industry. Diversification decisions were generally influenced by overall portfolio considerations, such as currency exposure, allocation size, and build up, etc. Often, however, decisions were also based on soft factors, including the behavior of other institutions.

The ongoing collapse in private equity portfolio valuations has caused many investors to realise that certain segments in private equity behave differently from the perception. Even (historically) conservative, safe and capital-intensive sectors like buyout financing may not deliver the expected returns. Even so, investment into new platform technologies and new business concepts remains high, suggesting that requirements on the supply side of the universe of private equity managers may change in the future. For example, we could ask how the buyout industry will come up with the additional capital required to finance the continuous re-building of enterprises, given the ever-increasing new platform technologies or business models financed by venture capital. The fundamentals governing diversification and return expectation in private equity are now being questioned. Risk premium considerations, diversification strategies using geographic and stage allocation models, and the like, all need to be reviewed to reflect the impacts of the collapse in private equity, and to take into account the “new environment” that began last year.

Historical diversification models
In the past, models for diversification emerged along with the latest trends in private equity financing. For example, success in the early 1980s with US venture capital led many institutions to make venture capital investments at this time, only to get hurt when the computer frenzy ended in the late 1980s. The same scenario occurred in venture capital in the mid-1990s. Venture capital in the United States and Europe financed over 15,000 new companies in 1998 and 1999. The economic slowdown and, primarily, the pace of the emergence of new platform technologies and business models, suggests that only about 20 per cent of these companies will actually be meeting an economic need in the industrial landscape of tomorrow. Additionally, we know that Moore's law (which states that computing power doubles every 18 months) will hold for at least another 15 years in the semiconductor industry, and can be applied beyond the semiconductor industry as well. This further supports the proposition that about 80 per cent of venture capital investments, which are mostly companies with incremental business content (the so called “me-too” companies), are headed for trouble. Additionally, this means that current buyout investments have a different risk profile as well.

A similar pattern can be observed in buyout financing. The fabulous success in the US buyout sector in the late 1980s led to a significant inflow of capital into this sector in the US and Europe in the early 1990s. The attractiveness of the capital markets, and their upward trend, allowed investment managers to model investments with the expectation of an early exit. At the same time, the buyout sector became quite efficient: auction processes, standard practice in the large cap buyout sector, led to higher transaction values. The prices paid make it difficult to achieve high returns today, given lower valuations and a closed exit market. This fear of not being able to exit in a timely manner is fuelled by the rapidly developing high tech sector which, and this is new, is beginning to question the many so-called ‘safe' business models of established enterprises.

Diversification models evolved alongside the development of the three private equity sectors (venture capital, development capital and buyout capital). Similarly, geographic diversification models tracked the emergence of private equity on the various continents, and have responded to developments in the world's various public markets.

Consultants, gatekeepers and fund-of-funds managers began to develop allocation models using various coefficients from ‘historical data', although some just followed market dynamics. Further, especially in Europe, the financial community accelerated the securitisation of private equity. In all the models applied over the past few years, the notion of sufficient ‘liquidity' has been assumed. However, today, about half a trillion US dollars (diversified by sector, geography or stage) has been trapped. It was invested on the basis of beliefs that were developed over almost a decade, but these beliefs may no longer apply, given the radical discontinuity in this sector. In short, historical statistical data is distorted, and the diversification models employed during the exuberance of the 1990s are now in question.

Diversification strategies in jeopardy
As the dust settles following the collapse of valuations, it is hard to find anyone quoting performance numbers, yet only a few months ago everyone was claiming to be an upper quartile performer! It is worth remembering that only a single digit percentage of private equity managers were able, historically, to generate so-called upper quartile returns continuously, and that a comparable public market index like a 10-year S&P index was, historically, above the median achieved in the private equity industry (Venture Economics/Asset Alternatives).

Recent experience has taught us that two private equity sub-sectors, later stage venture capital and large cap buyouts, correlate highly with public markets. Large buyout investors now know that a median of less than 1.5 for investment realisation multiples (ie. the ratio between returned capital, including unrealised values, and paid-in capital), as seen in the early 90s, is not sufficient to absorb the impact of a fast-changing environment and longer holding periods. In venture capital, venture fund portfolios that contain many companies with incremental business concepts correlate strongly with public equity. Further, those investing in private equity in the emerging markets like Eastern Europe, Asia and Latin America are taught that a significant risk premium may be needed as adequate compensation for the various macro risks.

In the past, investing in the secondaries market (ie. the purchase of limited partnership interests from an existing partnership) has been an attractive option, provided there were ample options for exit. Now, since many of the investment companies with incremental business concepts may never see an exit, this investment sector may also have to redefine its practice. Additionally, the requirements for investing in this sector, which provides an entry level strategy achieving early deployment of capital and early liquidity, may be different in the future.

The collapse in valuations suggests that more diversification may help risk control. But what about the increasing interdependence between the various sectors or industries? This is an important point to consider, especially when the average time to exit may again become again five to seven years.

The emergence of new models
The financing of new platform technologies and business concepts is continuing at the same pace as it was through the turn of the millennium, mostly by the proven investment firms. These firms have the luxury of being able to leave their ‘dogs' behind. They are now concentrating on new investment opportunities, where they can take sufficient time to build sustainable companies with proven management teams. This suggests that, within the venture capital sector, access to such firms will become crucial.

Continuous technological improvements result in the compression of the scale of new businesses, and the time taken to bring them to market. This will accelerate the emergence of virtual business communities, and will dissolve the barriers previously experienced by borderlines, and by oceans. As in the public markets, hypes and falls will follow each other more frequently in the private markets, affecting all business sectors and stages. Industry or cost structures in the more established industries, traditionally the domain of the growth capital and buyout specialists, will be heavily influenced by emerging business models and new technology companies.

At the turn of the millennium, many private equity investment managers began to realise that the three private equity sectors have some important commonalities and, if you control both sides of a specific industry sector, this provides an excellent investment opportunity. About a dozen venture and buyout firms began experimenting with this idea by collaborating with each other. The late stage venture fund Ameritech (collaboration by Accel, Oak and Brentwood) or the early stage/buyout collaboration Accel/KKR are examples for the sort of collaboration we may see in the future.
Conclusion
Institutional investors will have to identify and adapt to emerging practices in private equity management. Also, to maintain the enhanced returns expected of private equity investments, institutional investors should be able to answer questions such as which philosophies, which styles, which sectors and which teams will be continuing to provide superior returns five to seven years from today. These aspects of successful private equity investing, which I believe is an opportunity business rather than an allocation business, may become even more important in this fast-moving new environment.

Bruno E Raschle is the Managing Director of Adveq Management AG

Adveq Management offers expert management in private equity fund of funds to provide for start-up, expansion, buyout and development financing. For more information, please visit www.adveq.com.

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