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Coming of age

The private equity industry is seeing a sustained interest among pension funds, both in the US and in Europe. Nadine Wojakovski, writing for Global Pensions, examines the attractions of this asset class.

In the US the private equity and venture capital industry, which began in the 1960s, today forms a significant part of the two to three per cent allocated to alternative investments in institutional investment portfolios. So developed is the industry that it is estimated that as much as 50 per cent of investments in private equity and venture capital come from institutional public and private pension funds.

Despite this success, last was a very different year for the US, particularly the venture capital community. The combination of significant market volatility, declining valuations and much uncertainty has no doubt led some pension funds to rethink their future strategies. Ironically, while some US investors may be seeking to liquidate their private equity investments, some European investors are seriously looking into this asset class.

Although Europe is a late developer in terms of private equity investment, activity to date has been promising. According to the European Venture Capital Association's (EVCA) last annual European private equity survey, conducted by PricewaterhouseCoopers, European fundraising reached record figures for the first year since 1995. Pension funds were the largest single source of capital at E10.7bn or 24 per cent of total funds raised - up 125 per cent from E4.7bn a year earlier. Moreover, it was the UK that led the way as the biggest fundraiser of all European countries surveyed.

The £1bn Surrey County Council pension fund is unusual in that it started investing in private equity as far back as 1986. It currently has £12m cash out of a £27m commitment, spread among direct investments, limited partnerships and global fund of funds. It plans to commit £30-50m over the next year or so, which represents three to five per cent of the fund. ‘Our fund is not mature, but rather cash rich to the extent of £40m per annum and therefore private equity as an alternative investment is not risky for our circumstances,' explained Mike Taylor, director of performance and resources at Surrey County Council.

Taylor said doing an asset liability model study is a good starting point for any pension fund thinking about private equity. Through the study the investor seeks to ascertain what the liabilities will be, say, over the next ten years and then seeks to explore what the best asset mix is, given the liability profile.

Broadly speaking, this would mean that private equity could be a consideration for an immature pension fund that can afford to take the time for the returns to mature. By contrast, for a mature pension fund, which is declining as it pays increasing amounts to pensioners, there is a need for more certainty, which would mean a much higher fused interest ratio and therefore less room for alternative investments. 

Private equity has become recognised as an asset class that offers potentially high returns and a somewhat higher risk and diversification from a more traditional portfolio of marketable securities. ‘The fact that you can't invest all in one go, makes it a, sensible and an automatically conservative way of building up a portfolio,' observed Stephen Breban, a senior consultant at Watson Wyatt. ‘As you don't buy all investment in one year but over around seven years, the average should be good'. Indeed, its unique selling point, as has been witnessed during recent difficult times, is that it is highly unusual for an entire commitment to be invested in one go. ‘Some may have begun at the peak of the market but will only have invested a small proportion of the target level by the time the fall out happened," added Breban.

That said, inexperienced German private equity investors were shaken by the fall in the equity market last year, said Alexander Leisten, managing director of Oppenheim Capital Management, the asset management division of German private bank Sal Oppenheim. ‘They faced severe problems with their hidden reserves, and, in line with reducing their equity portfolio, they have become more cautious about investing in alternative investments such as private equity.'

Germany's restrictive tax and legal environment, in connection with foreign investments, has largely hindered the growth of this asset class. A recent study indicated that German investors would like to increase their average weighting of one per cent of net asset fund value to 1.5 per cent by the end of the year.

Fund of funds have grown dramatically in recent years. In the EVCA's survey for 2000, they accounted for 11 per cent of total funds raised, up from a modest four per cent in 1999.

A fund of fund tends to invest in ten to 20 limited partnerships, of which each limited  partnership invests in ten to 20 investee companies - thus giving exposure to between 100-400 investee companies, but more usually 200 to 300 situations. At the other end of the scale are the very large European funds, which invest in developing in-house teams to select the best funds themselves. Alternatively, they may co-invest in an investee company.

The target return for the Oppenheim fund of funds is six to ten per cent above the equity returns net of all fees. Fund of funds tend to offer higher returns than the five per cent over and above quoted returns that investors should expect from direct investments.

Surrey County Council's track record to date for direct investment has been very encouraging at 16 per cent per annum compound return. Its target on direct investment is the FTSE index plus two per cent. For new investments it expects to get FTSE plus three to five per cent. Taylor conceded that it is an ‘odd target' because returns tend not to be correlated with these markets.

Many of the large pension fends have set themselves a target of around three per cent of net asset value to private equity. Breban, however, prefers to look at the asset allocation in relation to the overall equity allocation, and not just the total assets. ‘We are prepared to advise clients to invest anything from five to 20 per cent of a pension fund's equity portfolio in alternative investments, which also includes property and hedge funds. ‘There are, of course, other issues to consider such as the funding level, the strength of the parent company and the risk return requirements of all parties.

The downside to private equity is the fees. Direct funds charge 1.5-2.5 per cent per annum of commitments, which amounts to 2.5 to four per cent of funds invested, with an additional 20 per cent on all profits. This compares to the more modest fees of 0.5 0.6 per cent per annum for about £50m of quoted equities. Fund of funds are even more expensive as they pass on the underlying managers' charges with additional charges on top. The extra charges, on top of the fees for direct funds, could be one per cent of commitments (which equals about 1.5 to two per cent per annum of invested funds), plus, in some cases, a further charge of five per cent of profits too.

The variety of fund choice and experience offered in the US market still remains a magnetic attraction to European investors. It is estimated that around 70 per cent of European money is currently invested in US funds, although this is set to fall to 60 per cent in the near future as the smaller end of the European buy-out and technology markets grow.

In terms of pricing, Gerry Degaute, director of finance at the Consignia Pension Plan, formerly the Post Office Pension Plan, believes that now is a good time to be an investor in private equity. ‘My perception is that the entry price has now reverted to normal prices, which are much lower than the inflated prices of the late nineties. I think there are drivers for investing in private equity, the first of which is the currently overpriced listed equities.'

On the whole there appears to be a sustained level of interest in private equity in Europe. The major players are the countries that have well-developed pension fund systems such as the UK, the Netherlands, Switzerland, Sweden and Denmark. Conversely, in the US, many investors are nursing their wounds experienced from the fallout. According to Venture Economics' Private Equity Performance Index US portfolio valuations fell to $51.6m in the third quarter of 2001 from their high of $93.1m in the fourth quarter of 2000.

Commenting on the findings of the Goldman Sachs/Frank Russell alternative investments survey, Hal Strong, managing director at Frank Russell Capital, conceded: ‘Allocations to private equity have grown in the US, but the pace of this growth is now slowing. However, we are seeing more meaningful increases in allocations particularly in the UK and we expect this trend to continue.' Moreover, with the EVCA discussing measures with the EU to foster and expand growth in entrepreneurship, through favourable tax treatment and harmonised fund structures, private equity in Europe looks set to have a strong future ahead of it.

The institutional market for private equity funds in Europe is, by and large, continuing to grow by both number of participants and allocations. The traditional structure of ‘a one shape fits all' with a ten-year limited partnership structure is also likely to change as investor demand increases.

And with the experience of the investor comes analysis. With around 4,000 funds globally managed by over 2,000 firms, in an industry that is not rated highly in terms of transparency, investors need to know how to identify the significant performance differentials among fund managers. The frequency with which private equity funds - or general partners - claim they are ‘top quartile' has led investors to realise how critically important due diligence is. No matter how different the investment approach is, investors are focusing in on managers with a unique and defensible investment strategy, demonstrable track record and cohesive investment team. Post 11 September it is only those private equity firms with a track record and real story that will be able to generate new business from pension funds.

Copyright © 2002 Global Pensions

Nadine Wojakovski is a freelance journalist.

Global Pensions is the leading international pensions magazine, reporting monthly on key developments in the pensions industry worldwide. Each issue contains vital and exclusive news coverage, in-depth country and regional profiles, comprehensive analysis and investment based features, profiles of major pension funds, key mandates won and lost, as well as essential statistical information. (Contact: www.globalpensions.com  Advertising: rhill@msm.co.uk, Editorial: scott@msm.co.uk). Subscribers also get access to the daily online pensions news service, International Pensions News (www.interpens.com).