PRINT THIS PAGE

Through the ages

The late 1990s will go down in history as a period of excess and profit for private equity. Since then, investors, fund managers and entrepreneurs alike have all come back to earth with a thud. However, Jan Faber of Henderson Private Capital argues that private equity continues to be an attractive investment for pension funds but it is important to look at these heady times to analyse the impact they had on fund managers – and the lessons to be learnt.

Looking back

Returns for both venture capital and buy-out firms were exceptionally strong over the latter half of the 90s and top quartile performance figures were often triple digit for venture funds. There was also a tremendous acceleration of the investment cycle. The full cycle had historically taken at least, three to four years but funds established in 1998 and 1999 were often raised and invested in less than oneyear. At the same time, distributions and returns to investors were robust as fund managers were able to capitalise on the exit opportunities offered by the buoyant M&A and IPO markets and the inflated valuations, particularly for technology companies.

Excitement surrounding private equity resulted in unprecedented commitments to both venture capital and buy-outs. In the US alone, US$154bn was committed to private equity in 2000 compared to only US$11bn ten years earlier.  As a result of this capital raising, many next generation funds raised three, four or five times more than their predecessor funds and many managers succeeded in raising capital without showing significant realised performance on previous funds. The promise of the unrealised write-ups of portfolio companies was, in the eyes of the investors, enough evidence of value creation to justify committing significant new amounts of capital. People just assumed that the ‘blue sky' paper IRRs were for real. And then the party ended. The collapse of the tech valuations on the Nasdaq resulted in the evaporation of most of these paper profits and some funds that were once considered as top quartile performers actually ended as net losers of capital.

How can this fund raising frenzy be explained? Clearly, investors got carried away by the unprecedented high returns - often triple digit - and the fear of being rejected in the future by the ‘hard to access' managers if they decided not to invest in their current funds. Without doubt, the managers were calling the shots and investors followed them as lemmings. The notion of ‘invitation only' fund managers had clearly created hype among investors. This triggered a dangerous cycle where common sense and rational investor behaviour were non-existent. Fortunately, the bursting of the dotcom bubble in April 2000 has resulted in putting the power back into the hands of the investors.

So where to from here for private equity?  The industry is facing an economic environment characterised by dower growth, a difficult IPO market, scarcity of leverage and a large overhang of capital that was raised over recent years and is awaiting good investment opportunities. Another reality is that fund raising will undoubtedly become more difficult for both fund managers and entrepreneurs. US institutional investors have been the biggest source of capital in the past but many have now reached their allocation limits or are already over-allocated. Non-US investors' allocation levels are still relatively low and are expected to grow over time how-ever.

Many venture capitalists will be preoccupied with their current portfolio companies and will take their foot off the gas in the short term, making fewer investments and retaining much more cash for follow-ons. This is high-lighted by investment activity in the US venture capital market, which has declined for six consecutive quarters, returning to nearer to1998 levels. The current conditions are fostering a return to building real businesses, as opposed to quickly flipping businesses with steep valuations benefiting from the booming inflated public markets.   For buy-out firms, the approach of creating shareholder value through leveraging capital structures will not be enough to satisfy investors. In the first place, under the current circumstances, leverage is much harder to get in the US. In the second place, leverage will not create value for the investors on a risk-adjusted return basis. When analysing buy-out track records, we always try to eliminate the impact of leverage from the reported returns in order to get a sense about the 'real' value that has been created. ‘We believe that buy-out managers, devoted to creating operational improvements and/or growing the revenue line, will succeed in generating attractive returns in this environment where leverage is less available and economic circumstances are more difficult.

We believe that the ideal venture team consists of individuals who have themselves founded and managed technology companies in the past. Many of the 400-plus new fund managers that started their funds in the last three years, and who thought they could make a ‘quick buck' by jumping on the bandwagon, will disappear.

After the significant growth in fund sizes experienced over recent years, the question remains about whether private equity firms will follow in the footsteps of the investment banking industry, which has evolved from a cottage industry into, a sector dominated by large international franchises. Although we see a growing institutionalisation of private equity firms, we do not believe private equity firms are easily scalable, although there are as always a few exceptions. Typically for fund managers, scale (the amount of capital they manage, the number of deals they pursue, the size of their portfolio) creates a level of complexity for which most firms are not equipped. For example, the average successful firm in the US now manages ten times the money it used to manage five years ago but only has about 50% more partners. We do not believe that this growth is sustainable and we expect many firms to become victims of their own ambitions. Many break-ups can be expected. Another problem is that an increase in fund size will generally force fund managers to adopt a different investment strategy than was executed in the past. There are many examples where venture funds that were successful as early stage investors are now pursuing later stage deals. Similarly, many buy-out firms with a historic 'sweet spot' for mid-market transactions are migrating upwards to the highly competitive large buy-out market.  

Fund of funds fulfil an important role in enabling institutional investors to access the best managers and the market has experienced a tremendous growth in them. With the increasing number of fund of funds players, we expect a consolidation during the next few years, with many of the smaller independent managers disappearing. At the same time, more differentiation and specialisation can be expected. Over time we expect a significant divergence between the performance of the various managers, which will demonstrate that fund of funds managers actually have a significant impact on the ultimate returns.

Relearning the basics

The ability to establish a diversified private equity exposure is a prerequisite. This means appropriately diversifying across fund managers, investment stages, sectors and regions but it also means diversifying across time. Absolute returns from private equity will from time to time be influenced by issues such as die availability of debt capital for leverage, the strength of the listed markets to support exits and the availability of committed capital to the asset class. Over time, however the quality of available private equity managers, the imbalances of information availability and the greater control available to investors with regards to management, financial systems and exits will result in higher returns being delivered to investors. Private equity programmes should not therefore be a one off allocation but should be consistently invested over time.

It is also key to choose quality managers. Top quartile performers regularly return more than double the returns of the median manager thus underscoring the importance of identifying and backing the best available teams and management talent. Investors often spend a lot of time on quantitative spreadsheet analysis on past track records but forget that private equity is all about backing talent and teams, as opposed to investing in franchises or institutions. It is also important to highlight where track records actually came from (luck or skill?), which of the team members actually delivered it and what is the involvement of these team members going forward. Many teams are currently heavily involved in managing their existing portfolios therefore making it difficult for them to chase the opportunities that have delivered for them in the past.

Investors should look at which individuals have been doing the deals over the last two or three years and what the transition and succession plans of a firm are for the future. Teams change over time to cope with different circumstances and because successful partners retire. You cannot underestimate the importance of having a cohesive team with a strong sense of mutual respect and cooperation, as opposed to a collection of deal junkies that compete with each other. Since private equity professionals often have strong egos, teams are susceptible to challenging dynamics, in particular when times get tough, such as those we are facing today.

Conclusion

In our view there is no basis to be pessimistic about the future for private equity. No doubt Darwin will do his job in the near future; weeding out the weak managers. After all, success in this asset class is highly correlated with the talent and motivation of the individuals, and the dynamics in the teams. However, these are all very qualitative factors about which an investor has to make a judgement.

But looking to the future, private equity has proven over the long term that it outperforms other asset classes and successful investors will continue to be the ones who focus their efforts on assessing the people and the teams.

Copyright © 2002 Global Pensions

Jan Faber is head of fund investments at Henderson Private Capital.

Henderson Private Capital is the international private equity house of Henderson Global Investors (the wholly owned asset management arm of AMP Limited). Its investment activity covers a wide range of sectors within the private equity market including venture capital, expansion capital and buy-outs. It also specialises in infrastructure investments and provide a range of investment banking services. For more information please visit www.henderson.com