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Nothing ventured, nothing gained

The losses incurred by high profile private equity firms in recent months have created an air of caution among institutional investors. Tord Stallvik of Schroders Alternative Investments Group argues the benefits behind a fund of funds and why managers with proven track records should continue to outperform.

With the media picking up on high profile losses in private equity portfolios, what can investors really hope to gain from such an investment? For the risk-averse or first-time investor, private equity funds of funds offer a portfolio-diversified route to higher potential returns.

Private equity funds of funds, or multi-manager funds as they are more commonly known in Europe, are investment vehicles that pool sums of money in order to invest in various private equity funds. They essentially come in two forms; limited partnerships and listed funds of funds. Both structures offer diversification, but the latter often has a lower minimum commitment and a greater potential for liquidity in the future, making it a suitable vehicle for private investors.

There are more than 30 private equity funds of funds in Europe. Ten of these are quoted companies, with the majority being listed on the London or Swiss stock exchanges.

A typical private equity fund of funds will invest in 20 to 30 underlying funds. Within these the spread by geographic region, investment stage and sector will vary, depending upon the investment knowledge and expertise of the team. Some teams will only invest in specific geographic regions, while others will pick a particular sector such as technology and become niche experts. However, the majority of fund of fund managers believe it makes sense to have a broad-based approach.

Private equity groups are renowned for showing a mixture of figures when they are seeking capital from investors; returns for realised companies only, selected sector investments only and realisations before the cost of managing the portfolio. To unravel the real facts behind the numbers requires the help of an experienced manager to ask the right analytical questions.

Of 2000 private equity groups worldwide, more than 600 funds are in the European market. With such a high number it is unsurprising to discover that the ranges of returns are wide and the difference between a good and bad private equity group can be huge.

In the late 1990s, during the dot-com era, investments in small emerging IT companies which the investment banks took very quickly to initial public offering, were very lucrative. As a result, many private equity firms changed their strategies, investing in areas where they had little or no expertise, trying to catch the technology boom and strong bull market. Besides lacking in experience, many of these firms let the usually rigorous due diligence process be forgotten. Following the technology bust and declining public markets, fund valuations have fallen sharply.

However, private equity as an asset class has been around since the late 1950s. It has weathered many an economic cycle and public market decline and the fundamentals of successful investing have not changed. Private equity still aims to outperform public markets by five per cent over the long term.

Private equity should be viewed as a medium to long-term play. A private equity manager's main aim is to build value within portfolio companies, usually by taking a majority control of portfolio companies and effecting strategic and operational change. This cannot be done overnight and as such the average holding period for private equity investments is typically four to five years. This, coupled with the illiquid nature of the underlying assets relative to quoted markets, means that investors need to take a medium to long-term view of potential returns.

Although the performance of the fund of funds manager will be dependent on the overall performance of the underlying private equity funds, private equity managers that have proven and successful track records of investing through economic cycles and creating value for their investors should continue to outperform. The fund of funds managers that can access these funds, in addition to identifying the next generation of top-quartile performers, should be able to provide investors with the desired out-performance of public markets.

UK pension plans are now looking very seriously at increasing their allocations from less than one per cent to 3.5 per cent of assets and many are working with the consulting community to plan theft future strategies.

Defined benefit pension schemes have been and still are large investors in private equity. However, with the general shift to defined contribution schemes, it is expected that interest from private investors will increase.

Copyright © 2002 Schroders Alternative Investments Group

Tord Stallvik is a senior member of the Schroders Alternative Investments Group.

Schroders is a leading independent international asset management and private banking group, with nearly 200 years experience in financial service and over £110 billion funds under management. For more information please visit www.schroders.com