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Successfully riding the private equity cycle: an institutional investor's perspective.

Institutional investors should look beyond yearly returns when considering alternative investments – especially private equity. Maximilian Brönner of LGT Capital Partners offers an insight into how institutional investors can build a well-structured private equity portfolio, based on longer term prospects.

In 2000 European venture capital funds invested a record E19.6 bn into seed, start-up and expansion opportunities, up from E10.6 bn in 1999.  The increase of private equity in the investment focus of mainly institutional investors, spurred  by recently created exits routes in major European countries, tax reforms and a new breed of motivated people seeking to fulfil the European way of Silicon Valley has made venture capital investing the flavor of the year.  While in 1999 the European buyout industry still accounted for 57 per cent of all new investments, this trend was reversed in 2000 with 56 per cent of new money raised going to venture capital firms. The enthusiasm for private equity was such that leading consultancy firms and investment banks lost some of their talent to newly created venture capital firms and numerous incubators established across most European capitals.

While stock markets have produced healthy double-digit percentage gains over the past years, top-quartile venture capital funds have been racking up triple-digit returns and attracted ever new investors to the asset class. Apparently, many investors seemed to have forgotten the difficulties in the technology sector dating from the late 1980s and early 1990s, when European venture capital returns were in the single digits.  In fact, European venture returns on a 5-year rolling basis remained single digit until the 4th quarter of 1995 and reached their peak of 27.8 per cent in the third quarter of 2000.

Following the drastic correction of Europe's newly created technology stock markets since March of 2000 and the tightening of new financing for many early stage companies, venture capital returns have come down substantially.  Venture Economics returns for 1999 showed a 38.8 per cent return in Europe and 146 per cent in the U.S.  Obviously, this exceptional performance could not be sustained for a long time and returns for 2000 came down to 17.8 per cent for European venture and 26.9 per cent for the U.S. 

However, institutional investors should not focus on yearly returns when analyzing and comparing different asset classes, particularly private equity.

The only return that really counts is that achieved over a 10-year or longer time horizon. Currently 10-year venture capital returns stand at 29.3 per cent for the U.S. compared to 19.2 per cent in Europe.

The current environment is such that numerous venture capital firms find it difficult to raise new funds and some have even returned uninvested capital back to their investors to account for a changed investment climate.  As the global slowdown has made it more difficult to attract new funding, venture capitalists now focus more on building their existing portfolio companies thus showing a preference for later stage financing, rather than seed and early stage.

Amidst  a difficult environment in the IT sector and many software and telecom companies struggling for new financing and customers, one sector of the venture capital market appears to be holding its own.  The life science sector, an area where Europe has traditionally been strong, has seen a revived investor's interest.  European healthcare businesses make up around 14 per cent of Europe's equity markets and European universities and research centers have established an undoubted reputation in their field.   As technical excellence and expertise are required to create new biotech firms or to raise first time venture capital firms the sector has experienced a smaller correction than that experienced in the IT markets.  After some difficult times in the mid 90s, biotech, medtech and related sectors find their way back into institutional portfolios as traditional venture capital firms raise their target allocation to life sciences and increase the size of their teams.  Investors have come to realize the profound impact new drugs and discoveries are having on human life and quality of life, especially when combined with latest developments in information technology.  But despite recent successes, the U.S. is still the largest life science market with massive capital and resources available.  In order to build worldwide companies, Europe's leading life science investors have had to combine their local knowledge and technical expertise with access to U.S. markets and know-how. To overcome some of Europe's structural disadvantages, Ernst & Young's Eight Annual European life science report even called for the creation of a common European pharmaceutical market and recommends to agree on common patenting and drug registration procedures.

After the overextended demand for venture capital, European investors as well as their U.S. counterparts find new value in buyout and distressed opportunities. In 2001, in an effort to return to a more traditional pattern again, an increasing allocation of capital will go to buyout firms while first time venture capital firms see some of their people leaving to join traditional buyout firms or find hidden values in turn-around situations.  It remains to be seen whether investors realize that just exchanging their venture capital overweighing with large buyout does not necessary translate into higher returns. In particular in a market where competition for large buyout transactions and corporate spin-offs has increased significantly and many of these deals find their way through the auction process, sometimes attracting a large number of bidders.  The beauty and source of long and sustained outperformance of venture capital and private equity stems from strong investment teams with proven track record acting in intransparent and inefficient markets.

Analyzing the different fund raising and return cycles over the last 20 years makes one thing very clear: the perfect timing in an asset class which requires long-term commitment and does not offer daily liquidity is rather impossible.

Therefore, an institutional investor should diversify its portfolio among different markets, types and stages of investing.  Diversification between venture capital and buyout as well as between Europe and the U.S. is needed to take advantage of different cycles and provide diversification regarding currency and economic cycles.  The vintage year diversification enables the investor to take advantage of different pricing and liquidity cycles.  Looking back at the 1999/2000 time frame, many venture capital investors probably would wish to have achieved a broader vintage diversification of investments in their portfolios.  For investors that recently invested in private equity the acquisition of secondary portfolios can be very attractive but is a rather complex process in terms of pricing and evaluating properly.  Benefits include the increased diversification of risk provided through a variety of vintage years and the expectation for earlier returns which are especially important to investors entering the asset class or having to deal with regulatory issues.

Even more important than diversifying over geographies and vintage years is the ability to pick the best managers out of more than 2,000 fund managers.  In a way, private equity investing is like trying to chose among 2000 mutual funds where there is no market for pricing, performance comparison and only limited information is available.  Single fund investments have a very different risk/return profile compared to investments in funds-of-funds or investment programs and investors without the required resources or access to critical information should only invest via that route with great care.  As with most asset classes a proven track record and a strong alignment of interest with the investors interest is paramount when picking a manager.  But a well structured and thoroughly executed private equity program will offer institutional investors superior returns and less volatility in turbulent public markets and compensate for the effort of investing in this asset class.

Copyright © LGT capital Partners 2001

This article first appeared in an EVCJ supplement on Germany

LGT Capital Partners is one of Europe's leading private equity and hedge fund investors and multi-manager Programme managers. LGT Capital Partners currently manages over EUR 1.7bn in private equity assets on a global basis and over EUR 800m in hedge funds.

LGT Capital Partners acts both as principal investor and investment manager, with clients investing on equal terms alongside its own capital. As a principal investor, LGT Capital Partners' primary objective is to achieve superior risk-adjusted returns by accessing and actively investing in the most promising private equity and hedge fund investment opportunities world-wide.

For more information: aim@lgt.com or telephone: +41 55 415 9 415