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The asset class private equity – market opportunities in Europe19/12/2007. Source: Fleischhauer, Hoyer & Partner. Uwe Fleischhauer 
 Institutional investors around the globe are continuously on the lookout for high yield and new alternative investment opportunities to boost and diversify their capital income, writes Uwe Fleischhauer of Fleischhauer, Hoyer & Partner. As the stock market turned bearish in the spring of 2000 and continued its slump well into 2003, accompanied by a prolonged phase of low interest rates up to date, asset managers in banks, pension funds, insurance companies, foundations and family offices have intensified their search for alternative asset classes.
Even though conventional investment forms continue to account for the highest allocation of funds, the intent is to broaden the spectrum of investment opportunities within the scope of asset allocation to enhance opportunities to diversify into alternative investment segments. All institutions are striving to develop new investment strategies intended to counter declining returns.
Within this context, Private Equity gains importance. Still, there are those who continue to claim that this investment segment is complicated and lacks transparency. Thus, one prerequisite for investing successfully in the private equity segment is a certain level of experience, insights and network.
Private Equity is the term used to describe equity capital in companies not listed on a stock exchange and covers the whole spectrum of funding (venture and buyout incl. “special situations”). These types of investments are usually long-term in character and relatively illiquid since there is no real secondary market. Private equity serves exclusively to enhance the portfolio mix. In recent years, interest in private equity has grown continually because it expands the diversification spectrum, while offering higher returns compared with classic forms of investment. When investors contemplate taking the step into the private equity asset class, expected returns and risk structures are initially at the forefront. Many asset managers in leading institutions would like to become more active in private equity, attracted by these returns potential and risk differentiation opportunities – others, however, remain constricted in their investment behavior by a lack of transparency, corporate guidelines, or liquidity requirements.
Still, this asset class is a relatively young investment segment in Europe for institutional investors. With the exception of countries with “Anglo-Saxon character” (UK, NL and Nordic), European investors have focused on traditional investment forms. However, a shift in mindset toward private equity is taking place among leading institutions, and institutional investors are rethinking their strategies.
A private equity program needs to clearly specify overall allocations as well as sub-allocations into individual segments (regions, stages, etc.). Before doing this, it is important to select the right investment vehicles. In principle, investors can chose from three alternatives in pursuit of their investment strategies: investors can chose the most direct variant and identify individual companies to finance. Alternatively, investors can invest directly in individual (single) funds, or they can chose the most indirect variant by investing in a fund of funds (or by a separate account). Each of these variants is associated with a different risk profile and each requires a different level of operative resources and expertise – and each has a different returns potential and fee structure.
Prospective market opportunities will likely also prompt institutional investors to increasingly board the "private equity bandwagon” and to identify and search the correspondent vehicles and target funds, managers respectively for approaching a diversified portfolio of attractive regions and stages.
To implement the strategic planning regarding private equity, the overall investment guidelines have to be defined. In general, a decision should be taken to spread the future private equity portfolio over phases, regions, industries, and vintage years in order to achieve a high level of diversification and to avoid any risk of clustering. Prior to defining the quantitative target allocation and the weighting of the “microallocation” for different segments, the current market environment has to be examined and evaluated. As an example to follow, the following pages describe shortly the actual market climate in Europe as home market for local institutions focusing on current mid-market and venture capital opportunities:
Introduction to Europe
Although the history of private equity in Europe is much shorter than in the US, it was able to catch up dramatically in the 1990’s. Since the nineties, the private equity market has grown continually and significantly, reaching an annual growth rate of 26 percent (CAGR = compound annual growth rate) for the period from 1995 to 2006. Investments increased from EUR 5.5 billion in 1995 to approximately EUR 70 billion in 2006 in Europe.
However, Europe is still an under-capitalized marketplace in regards to private equity. Today, in terms of economic penetration, private equity investment in the UK amounts to 1.3% of GDP, leading by far other European key countries and comparable to the level in the US. On average, the European countries reach a volume of 0.57%, i.e. less than half of this amount. The relative under-penetration by private equity of the Continent (as measured by penetration of GDP) both highlight the considerable future growth prospects of private equity in Europe. This becomes clear when one considers the size of major European economies such as Germany - Germany with 0.3% is still behind by a factor of two in regards to the European average and by more than a factor of four behind the UK.
Europe – the current market climate
Following record activity levels in 2005, 2006 was another landmark year for European Private Equity and saw increased fund raising and investment activity: of the about EUR 110 billion in funds raised (a 56% increase over the previous year), about 75 percent is allocated to buyouts. While buyouts represent the main proportion of European fund raising by volume, there is evidence that the venture capital segment is making a comeback, with over EUR 17 billion raised for VC investments, EUR 6 billion (+55%) more than in 2005. This is the second highest amount raised after the EUR 22 billion all-time record of 2000. Regarding investments, of the total EUR 70 billion equity capital invested in 2006 (+50% compared to 2005), almost 80% relates to buyouts by volume. However, based on the number of investments, VC deals (incl. expansion) take up a 74% share (Source: EVCA, based on European private equity funds).
Thanks mostly to the successful fund-raising activities of large buyout funds, capital raised is currently being invested with a strong focus on buyout transactions. Transaction and fund volumes in the large buyout segment have taken on ever-larger dimensions. However, the current concerns relating to an overheating buyout marketplace, shifting interest to venture capital and the small and mid-market.
With regard to performance, top quarter funds in Europe continue to provide extremely strong returns to their investors with an impressive 23% delivered by all private equity since inception - Top quarter venture funds return a robust 17% since inception. Continuous improvements in returns over the past can be observed. The increasing alignment of returns from US-funds and their European counterparts also become apparent. The fact that Europe now achieves better returns in the buyout segment than the US underlines as well the attractiveness of the European market. However, looking back, the best returns were achieved in the US venture segment, reflecting also the different maturity levels of the two regions.
Market opportunities in European Venture
Continental Europe as a location for venture capital is often positioned in a negative light. Venture capital is considered to be an 'Anglo-Saxon domain' that cannot be cultivated successfully on the Continent. Potential investors still lack the necessary transparency to be able to accurately assess the opportunities of this segment. Thus, preconceptions often stop (potential) institutional investors from investing in European venture capital.
Yet, Europe as a venture capital geography is much better than it is reputed to be and has significant growth potential. Measured on the basis of innovation potential, Europe can make a quantum leap in venture capital. Indeed there are many good reasons to take a closer look at venture capital in Europe. Europe has many success stories, highly interesting technology as well as capital – all key prerequisites for a well functioning venture capital infrastructure. However, compared to the far larger Anglo-Saxon VC market, (Continental) Europe continues to be labeled an "emerging market" – one that offers high growth potential. Although local investors are still somewhat reticent, foreign institutions seem to have a better feel for the opportunities in the European VC market. The fact that new funds have been set up successfully is mainly due to the flow of capital from foreign investors (even US and Asia). Furthermore, the local VC industry has professionalized significantly in the past five years. On the company side, the number of experienced entrepreneurs is growing and there are now "serial entrepreneurs" who can build high-growth technology companies professionally with the help of venture capital. There are more than enough high-quality investment opportunities, not least because of the high technology potential in fields such as medical technology, Cleantech, laser/photonics, nanotechnology and wireless applications. There is less competition among VCs for technology companies in Europe than is in US, leading to investment opportunities at lower valuations. In the years 2005 and 2006, more venture-backed IPOs took place in Europe than in the US for the first time ever. At the same time, it is becoming apparent that only the best fund managers are surviving industry consolidation.
For 2008, we expect a further recovery of the European VC-market – both in terms of investment and in fund-raising. Confidence in the market is returning and performance expectations are improving.
Market opportunities in European Small and Mid-Market Buyout
Over recent years, the spectacular growth of the European buy-out market has made it a regular feature of press headlines. 2005 was a particularly strong year, breaking a number of records: the value of buyout investments in Europe hit €124 billion (Source: CMBOR, based on European transactions incl. foreign private equity funds), topping €100 billion for the first time and Europe saw its first deal in excess of €10bn. 2006 has continued this trend: the value of buyout investments in Europe reached €160 billion – a further 30% increase to the previous year. While press headlines have tended to focus on the top end of the market, reporting on the ever-larger “mega-deals” such as the buy-outs of Hertz and TDC, the European mid-market (deals < € 50 million enterprise value) has remained relatively low profile.
An empirical study of 33 leading European Mid-Market Buy-Out Funds produced by the Private Equity Consultants FHP (Fleischhauer, Hoyer & Partner) in 2006 confirms increased maturity in the sector, strong deal flow and lower risks going forward compared to the large buy-out market. The study concentrated on funds targeting the majority acquisition of companies valued below the €250 million threshold (with fund volumes on average of about €300 million): in 2006 as in previous years, the mid-market remained by far the most active segment of the market, accounting for about 90% of all European buyout deals. The mid-market has demonstrated strong and consistent growth over recent years with activity levels rising by 3% p.a. since 1995 and with the total level of annual investments growing by 9% p.a. During this period the mid-market landscape has changed significantly as Continental Europe has become increasingly prominent, catching up rapidly with the UK, the historic power-house in Europe.
European mid-market funds clearly focus on their buy-out core competencies. The target companies are typically concentrated in the €50 million to €100 million value range. One of the most important differentiating factors compared with the large buy-out market is the strong single-country focus. Unlike the large buy-out segment, the primary source of deals is succession issues and sales by family owners. Mid-market funds will add value primarily by providing portfolio companies with operational and strategic support – much less importance is given to pure financial engineering, which is becoming more and more a commodity. As demonstrated by our empirical analysis, the mid-market buy-out funds have shown a lower average level of leverage. In most cases, mid-market funds take majority position. In general, the mid-market is characterized by a lower level of institutionalization. There are almost 200,000 small and mid-sized companies with more than €25million revenues in Europe. The increasing acceptance of private equity as a source of capital and liquidity among entrepreneurs, family owners and large industrial groups creates a huge potential market for European mid-market Buy-out funds. The expected increasing deal flow will be driven by the financing needs of family businesses and generation change as well as the continuing industry consolidation in Europe. The development potential is especially high in continental Europe, with countries like Spain, Germany, and France seen as being particularly attractive for midmarket deals in the next few years, according to our respondents.
To conclude, the European Venture and the small/mid-market for buyout-financing are segments, which have not been in the public eye much until now, but it looks set to become two of the hot spots in the coming global private equity arena.
Fleischhauer, Hoyer & Partner advises institutional investors with regards to the market environment and the implementation of private equity as an asset class. For more information go to www.fhpe.de.
The presentation was prepared for the Private Equity World Germany 2007 conference organised by Terrapinn.
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