If a business is run down, struggling to grow, and in desperate need of a capital injection, it could be forgiven for thinking the writing is on the wall. Borrowing from banks has become more difficult in recent years, as the aftershock from the financial meltdown in 2008 is still being felt around the world.
However, many investors see struggling or new businesses as an opportunity for future growth. Funding can also be essential for larger businesses which, although successful, might wish to expand or take advantage of opportunities in the marketplace.
Private equity firms, generally set up as limited liability partnerships, look to capitalise on these businesses and seek to invest or acquire ownership by using investments or securing debt. Consumers have the facility to directly invest in the funds of private equity firms and, due to their risky nature, have the potential to deliver substantial returns, but also suffer large losses.
There is the distinct possibility that some funds could lose everything, especially if investment decisions end in disaster. Although only representing a small proportion of the market, some private equity funds have delivered stellar returns in recent years. But with a great number of challenges remaining, investors will be keeping a close eye on whether this will continue.
Chris McChesney, global head of alternative fund services at US-based private bank Brown Brothers Harriman, explains that private equity “is not a new segment”, and recent market changes have caused firms to take action.
“It has become a lot more crowded and competitive over a 20-year span. The number of private equity firms in the US has grown 20 times, while the number of companies has remained relatively static. Private equity funds have adapted to the crowded market by trying to get leaner, sometimes doing smaller deals, sometimes becoming more specialised,” he says.
Richard Hickman, director of investment and operations at HarbourVest Global Private Equity, says although the sector has experienced difficult times, the market is now under control.
“The industry is on a sustainable footing and is continuing to grow. Even though private equity has grown rapidly over 30 years, it is still at the smaller end of the scale,” he adds.
Big game
Given the nature of private equity funds – to generate large sum investment which can then exposed to severe risk – the most financially resourced investors are likely to be the main suitors. These will include institutional firms and large life offices such as Prudential UK, which recently invested more than $50m (£38.5m) into HarbourVest shares.
Investments from the various channels are then pooled together with the potential addition of debt to find quality early stage companies or those that require additional investment in order to grow. This investment could not only benefit the investors and firms involved, but also the economy, as the knock-on effects could mean more profitable businesses creating more jobs.
However, due to the inherent risks associated with new and emerging companies, private equity firms and investors need to exercise a degree of caution as investment into a failing company can prove damaging, even for the most diversified of portfolios. Mr Hickman explains that sometimes a sharp rise in fundraising demands could signal concerns for investors.
“A potential amber light would be where a manager is raising a much larger fund this time around. If, in 2012, management that raised $1bn (£771m) are now looking to raise $2bn or $3bn (£1.5bn or £2.3bn), then potentially there will be concerns around resourcing within the management team.”
He adds that this could present worries about its ability to maintain the same level of quality deal flow for a fund two or three times as large. In any case, it is important to conduct thorough in-house discussions before committing investment funds.
Opportunity in crisis
The 2008 financial crisis has had a significant long-term impact on borrowing, particularly in the UK. Commercial banks have reduced their capacity for lending, leaving businesses with no solution other than to explore alternative means. This gap in the market has opened the door for direct lending (or private debt), where capital for businesses is received straight from investors via capital commitment funds.
Mr McChesney describes interest in this area as “explosive”, as banks come under more pressure to reduce lending activities.
“The liquidity to fuel American and European businesses is now coming from alternative investments and fixed income managers who are filling a gap left by bank disintermediation.”
Performance
Private equity firms look to spread risk for investors by diversifying over a number of companies via a closed-ended investment vehicle. Because of this risk, returns in the sector have been mixed.
Table 1 shows the top 10 performing private equity investment trusts over five years. Returns over this period have been positive, with the average trust producing 8.21 per cent growth pa. These average growth figures have been buoyed by the performance of NVM LLP Northern Investors Company, which saw a return of £3,460 from an initial investment of £1,000 – a staggering 28.2 per cent pa over five years.
However, although not listed in the Table, an example of the risk to capital involved in private equity trusts is highlighted by Candover Investments. The trust has dropped 67 per cent and 52 per cent in the last two years, respectively, and a £1,000 invested 10 years ago would now be worth only £55.
“These are very long-term commitments – they’re illiquid. Each of our funds have a lifetime of seven to 14 years depending on the level of extension,” says Mr Hickman, who explains that the key within private equity performance is selecting the right managers then ensuring that this relationship is fostered.
What are the challenges?
According to the Preqin Investor Outlook Private Equity H1 2016 report, pricing and valuations represent the biggest challenge to investors seeking to operate an effective private equity programme in 2016, with 70 per cent of respondents of this opinion.
“Prices are high and that is something we have to accept,” says Mr Hickman, but he adds that asset quality has improved proportionately to this rise and value creation plans are more thought out than before the financial crisis.
Performance and deal flow were seen as the next two biggest obstacles for investors, at 40 and 34 per cent, respectively. For performance, this represents a large shift in investor optimism, as in 2014, only 21 per cent viewed this as an issue. However, confidence in private equity is clearly high as only 3 per cent saw due diligence as a challenge and 2 per cent were concerned about portfolio management.
Mr McChesney says managers entering the private equity arena require a certain sophistication and scale to overcome operational, regulatory and reporting costs to become successful. Not only this, reducing these costs will enable firms to continue producing competitive returns. But despite these challenges, interest in the sector continues to grow, he adds.
Private equity remains a small proportion of a very large and complicated financial industry. With many investors looking at alternative means, this small concentration may provide the diversification to deliver returns in a tough economic climate.
craig.rickman@ft.com
