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The fifth class

The US has historically been the undisputed leader in terms of investing in private equity. However, as Nick Lodge of I-Cap Partners discusses, the rest of the world is rapidly catching up.

Private equity is most often lumped into the alternative asset class and until recent years it has very much been a sideshow. This changed in the past couple of years, and today alternative investments - principally hedge and private equity funds - represent a credible fifth asset class for institutional investors.

In a publication by Goldman Sachs and Frank Russell: Report on Alternative Investing by Tax Exempt Organisations, the extent to which investors have increased their allocations is evident. While North American institutions continue to have the highest allocation to private equity at an average of 7.5 per cent of total assets in 2001 (up from 7.3 per cent in 1999), the interesting thing to note is the rate at which other investors are increasing their allocations. In continental Europe, the average allocation has increased significantly from 2.8 per cent in 1999 to 3.7 per cent in 2001.

As investors increase allocations it is worth perhaps considering where the investment dollars are actually ending up, given that the key to performance in this asset class, perhaps more than any other, is in the deal flow available to the various competing funds. It is therefore potentially of concern if an ever-increasing pool of capital is chasing the same few deals in the same few markets. 

Up until the late 1990s private equity investing was essentially a domestic activity confined to the US and the levels of investment were a fraction of what they are now. While there are signs that this US centric view is changing and non-traditional markets are starting to exhibit strong signs of growth, the relative significance of the US versus other non-traditional markets is clearly evident in the PricewaterhouseCoopers and 3i Global Private Equity 2001 Survey.   

The US accounts for approximately 70 per cent of all funds raised and invested in private equity. This leaves the rest of the world to share 30 percent of the $225bn raised, or just under $70bn. The survey also clearly shows the marked focus    on technology as a sector and in terms of stage a favouring of expansion capital. In terms of stage the 2000 data is slightly misleading as traditionally the majority of all private equity investing has been in buy-outs, which have typically accounted for in excess of 60 per cent of investments. In 2000 this trend was reversed for the first time.

So until recently private equity investment has been largely confined to something that occurs in the US and has been mainly limited to buy-out activity in the technology sector. The interesting thing here is, however, that when it comes to growth in private equity activity, be it in terms of funds raised or invested, the US is well down in the rankings. This doesn't include the matter of absolute size, where clearly the US outstrips all others combined.   

In terms of annual growth rate, the US is in a group with the likes of the UK, Germany and France. All of these countries have growth rates in the 30 per cent - 40 percent range, based on investment growth.

Two things are evident: one is that the UK has a relatively low growth rate, in fact the lowest in Europe. The other is that the US is outstripped in terms of investment growth by 12 other countries. The rate at which some of these non-traditional markets are growing is impressive.

While the absolute level of investment activity in any of these markets is low in comparison to the US, the level of growth and associated interest is a source of opportunity for investors. 

One thing to note from the table is that, in the majority of cases, funds raised exceeded investments made, indicating that in many markets capital will not be a constraining factor. This further reinforces the message that looking to non-traditional markets is perhaps worth considering as a means of accessing quality deal flow without the pressure from uncommitted capital that is likely in the US and certain other more established markets.

When considering investing in non-traditional markets there are a number of things to be wary of, especially given the fact that successful private equity investing is arguably difficult at the best of times. One approach that may be adopted is to look for and focus on markets that exhibit many of the characteristics of established, or 'traditional' markets and yet are outside of the mainstream at present. 

As an investor you are looking for some positive fundamentals, such as:

• Lack of competition
• Natural competitive advantage
• Positive regulatory environment 

An example of a region that has all of these characteristics is Australasia (New Zealand and Australia). 

The region also may be said to give investors more ‘bang for their buck' or otherwise exhibit what is known as value acceleration. This concept is based on the fact that a dollar invested in the region will go further than in say the US and yet the outcome in terms of value is the same, as the exit is achieved in the US or similar.   

The elements necessary for this to work are:

• Low cost entry to the ‘local' market
• Short time to market due to environment and attitude
• Use of ‘local' market as a testing ground and then scale to target market
• Exit in target market at target market valuation multiples   

Natural competitive advantage can be found in different forms, such as in Australasia where there is a positive macro environment that is conducive to successful new business formation and incubation. It may, however, be the result of a variety of reasons, some new, some long-standing. For example, at present there are a number of non-traditional markets that have positive outlooks for private equity:

• China - entry to the World Trade Organisation
• Japan - distressed debt situations
• Korea - government and tax incentives
• India - clustering of software developers
• Israel - high-technology start-ups and spin-offs from medical & military

As a general rule it is important for investors to acknowledge the potential for additional risk in non-traditional markets, this may be as a result of regulatory issues, lack of information or other risks - usually referred to as 'country risk'. 

In terms of the level of performance to be expected, or required, there are two approaches.  Either:

• an investor selects a 'non-traditional' market where the risk factors are not significantly different from more traditional markets and in fact for the reasons mentioned previously there may be additional opportunity, allowing the investor to target returns in line with industry norms - approximately 20 per cent.

Or

• an investor opts for a higher risk profile and invests in a market where they are seeking an industry return plus a premium for the additional risk they have taken on.

Clearly the choice depends on the investor's risk appetite and other factors. In terms of investment itself, this should be done through a team that is locally based and has local expertise, such teams can be accessed directly or through fund of funds depending on the experience level and resources available to the investor.

Private equity is not intended to be the main part of most portfolios - it's typically below five per cent of total assets - as such it should be kept in context. It is higher risk than other assets classes but it has a history of delivering higher returns. The challenge for investors is how to increase the chance of achieving the ‘premium' return they are seeking from this asset class, without having to assume levels of risk that might be expected to correlate to the return. Non-traditional markets represent one means of perhaps achieving this. Following the mainstream and investing in private equity in the US now will result in investors assuming a perhaps unrealised level of risk.

Faced with the issues outlined above, and the list is by no means exhaustive, the other option of selecting a low-risk, non-traditional market and making a commitment to a credible local team, fully cognisant of the risk issues specific to that market and where a suitable premium is available if necessary, suddenly seems to make sense. In deciding to go outside of the main market –the US - you will be demonstrating that you have thought about the investment decision and not simply tried to jump on the bandwagon of alternative investments.

Copyright © 2003 Global Investor

Nick Lodge is managing director at I-Cap Partners.

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).