The case for listed private equity – Part 2 – Types of listed private equity investment
An increasing number of investors are looking to access PE and LPE given the potential it offers to diversify portfolios and capture a meaningful source of return on investment.
This article from PAN-Tribal Asset Management is the second of a three part series exploring the investment case for listed private equity. In the first of the series, listed public companies are compared with private companies and the role of private equity is examined. In this second article, types of private equity investments are examined.
Private equity (PE) is ownership of, or interest in, a corporate entity that’s generally not publicly listed or traded, although PE is increasingly backing listed companies where there are opportunities for transformative growth.
PE managers tend to raise capital from high-net-worth individuals or institutions into PE funds, then use that capital to purchase stakes in private companies or acquire control of public companies (often taking them private) with plans to execute long-term value creation strategies.
Private equity investment vehicles can be listed or unlisted. Listed Private Equity (LPE) comprises entities listed on international stock exchanges whose main activity is investing in private companies, private equity funds or the investment managers of private equity funds.
Buyouts
Many of us are familiar with private equity buyouts; such transactions have long been a feature of the Australian corporate landscape. In 2020, Bain Capital’s $3.5bn recapitalisation of Virgin Australia was the country’s largest buyout deal for the year, while KKR’s $1.7bn acquisition of a 55% stake in Colonial First State Investments was another deal of note[2].
A buyout refers to an investment transaction where one party acquires control of a company, either through an outright purchase or by obtaining a controlling equity interest. The buyout can be funded through debt or equity financing – usually a structured combination of both[3].
The transaction often takes place in situations where the purchaser considers a firm to be undervalued or underperforming and has the potential for operational and/or financial improvement under new ownership and control. As with any other investment, a buyout will take place when the acquiring party believes there’s an opportunity to make a good return on investment.
For some companies, a buyout is part of the exit strategy, whether it be by a PE firm or a competitor. For others, a buyout may arise as the unintended consequences of poor management, unexpected circumstances or an unforeseen opportunity that arises.
While buyouts can take several forms, the two most common are:
- Management Buyouts (MBOs) and Management Buy-ins (MBIs) – Each provides an exit strategy for corporations that want to sell off divisions that are not part of the core business, or where owners may want to exit the business.
- Leveraged Buyouts (LBOs) – LBOs use significant amounts of borrowed money, with the assets of the company being acquired often used as collateral for the loan. LBOs often occur when a firm is taken from being a public company back to being a private company[4].
It is very important for the success of a PE-backed buyout that the acquired party has also undertaken sufficient due diligence on their new owners/partners. Rather than simply being viewed as just another transaction, each party is entering a symbiotic relationship where they will be partners for a long time. Therefore getting the right fit is paramount.
What is a buyout fund?
The buyout of a company requires a significant amount of capital. Generally, the PE firm would look to raise capital through a range of investors – traditionally larger institutional investors such as pension funds or sovereign wealth funds – and establish a PE fund with those pooled assets.
The PE firm would then look to source potential businesses as buyout opportunities and close these deals. Today it’s more common for PE firms to have a particular focus on specific industries and sectors, with their own firms having employees with the requisite skills and backgrounds that can be leveraged once in partnership with the acquired company.
Over the ensuing years, the PE firm would then work with the companies in the PE fund and look to affect a positive operational and transformational change in their respective businesses – along the journey, funding each phase with the assets of the company itself or the PE fund.
To return capital to investors in the PE fund, the PE firm – at what they believe to be the appropriate time – will look to exit the buyout partnership with each respective underlying company. The exit strategy may be executed in a number of ways, such as taking the company public or selling it to a trade buyer. Figure one highlights the typical lifecycle of a PE fund, along with the typical cycle for each investee company[5].
The PE firm stands to make a good return from the annual fee they charge the investors to manage the PE fund, usually around1.5-2.0% p.a. In addition, the PE firm will have negotiated a share of the profits made from the return on investment at the end of the journey; this is typically circa 20%.
The investors stand to make a multiple on their invested capital. Good PE firms that can affect significant transformational change on the underlying companies are capable of generating attractive multiples on invested capital. The attractive nature of the return potential from private equity has been a significant driver of growing investor demand and inflows into this alternative asset class.
As with all investments, investors need to be cognisant of the associated risks with the underlying assets in which they are investing. In the case of PE, the risks one should consider are that:
- invested capital is locked up for a long time – PE funds have a lifecycle often nearing 10 years
- many PE funds are concentrated on a small handful of companies (and potentially focused on a certain sector or industry)
- the returns for investors are significantly weighted to the back end of the PE fund’s lifecycle
- there’s not a lot of transparency and disclosure as to what the PE firm is actually doing – there can be long periods between communications to investors.
Traditionally, PE funds have been in unlisted, closed-end structures where the investor’s capital is locked up for the duration of the lifecycle of the fund (up to 10 years in most cases). However access to PE and buyouts continue to evolve, as more and more PE funds operate as listed vehicles. This creates an ecosystem where the PE firm has access to permanent capital to fund buyouts, and where the investors have the ability to exit more flexibility as there is the liquidity that comes with broader shareholders behind the listed vehicle.
PE backed listed companies
A PE-backed listed company is one where a PE manager holds significant equity ownership, or controlling stake, of that listed public company’s shares and, typically, has representation on that company’s board.
In the US, of the 24 IPOs in the first quarter of 2020, eight were backed by private equity firms. These deals raised $4.6 billion, a $4.3 billion jump in proceeds from the first quarter of 2019. The financial sector led PE-backed activity with three IPOs, with additional activity from healthcare, industrials, tech, consumer discretionary, and consumer staples[6].
What is the relationship between a company and a private equity partner?
Whether a company is private or public, it’s possible that any business can come to a junction in its journey where current management may simply lack the specific skills or knowledge to successfully navigate the company going forward or to tackle the next phase of growth. A PE-backer isn’t just simply providing a funding source, more importantly, it’s a symbiotic relationship that forms between a company and the PE-backer.
There is substantial empirical evidence to suggest that more companies are welcoming of PE-backing, whether they be private or public; it can be argued that the governance model is more conducive for PE-backed companies to plan and operate effectively.
While the comparisons presented in figure two specifically reflect the differences between PE-backed private companies versus public companies, the same positive characteristics and governance strengths would also be present in PE-backed public companies as well[7].
Increasingly, PE firms – whether looking for buyout opportunities or to back a public company – have become more specialised with managers often focusing on specific industries, sectors or aspects of the businesses lifecycle. Often the manager brings with them a broad range of skills and capabilities that management can draw upon, such as:
- knowledge of specific industries
- operational experience
- financial modelling and analytical skill
- customer, competition and market research.
Each of these factors can be leveraged to benefit the strategy and shape the direction of the company the PE firm is backing.
What is the investor’s perspective of PE-backed listed companies?
As a growing universe, PE-backed listed companies can provide investors access to listed companies where the PE-backer still has a significant equity ownership, board representation and ultimately the same transformational approach to affect positive change in the company. It is not dissimilar to a private equity ‘co-investment’, where other investors might sit alongside (i.e. share ownership with) a PE-backer in a traditional buyout of a private company.
While this universe is growing, it is not easy for an investor to identify a PE-backed public company as there is no global database or benchmark/index that consolidates and tracks these businesses. These companies are not well covered by the broader research community.
There are only a few specialist private equity firms and global equity fund managers that have identified this investment opportunity and spent the time and resources to (a) mine the market in an attempt to identify these companies and (b) undertake in depth coverage and research of these companies. Needless to say, investment management firms that pursue these investment opportunities do tend to be active, research driven organisations.
Alternative asset managers
An alternative asset manager (AAM) is one that manages alternative assets, i.e. investments that don’t conform to the traditional asset class categories of shares, bonds or cash. Alternative investments can include private equity, venture capital, hedge funds, real assets, commodities, derivatives and private debt.
AAMs specialise in these investments, which historically have been largely the domain of institutional investors or high-net-worth individuals, because of their complex nature. Despite the complexity, they are attractive to investors due to the potential for superior returns. These investments typically have common characteristics and are generally:
- illiquid
- in need of large injections of capital
- long duration, in that it can take time to generate returns.
Historically AAMs haven’t typically been accessible on public markets, however, over the past 15 years there has been a trend that has seen an increasing number publicly list; as a result, a number of AAMs are now accessible to smaller, non-institutional investors. Examples of such companies include Blackstone Group (BX), Apollo Global Management Inc (APO), Carlyle Group (CG) and Kohlberg Kravis Roberts/KKR & Co. (KKR).
There are several factors at play when an AAM considers listing, with the primary drivers being succession planning and attracting more permanent capital.
Unlike traditional fund managers, AAMs – particularly in private equity – manage the asset. These companies provide the resourcing and guidance to the private (or public) companies they buy, with the aim to transform them to be better and more profitable businesses.
AAMs tend to have well-resourced teams with specialists across a range of sectors and industries, providing skilled guidance to the private companies they source and financially back[8].
AAM Case Study: Blackstone Group
Blackstone was founded in 1985 as a mergers and acquisitions business. Over time, it has evolved into a diversified alternative asset manager specialising in private equity, real estate, credit, infrastructure and fund of hedge funds.
Blackstone manages funds on behalf of investors in private equity, real estate, credit, infrastructure and fund of hedge funds. It’s assets under management has grown from US$82bn across 15 strategies at IPO (2007) to US$684bn (at 30 June 2021) across 50 strategies today. This growth in AUM has been driven by increasing demand for higher returning alternative assets from institutional investors, particularly in an environment with record low interest rates.
Fund returns across its platform have been excellent, delivering mid-teen net IRRs to investors since inception in private equity, real estate and credit.
How AAMs provide diversification of returns in a private equity portfolio
AAM’s derive earnings from a number of sources – management fees, performance fees, transaction fees, and balance sheet portfolio investment returns. Management fees are levied on assets under management at a contractually stipulated rate. Though the amount of this fee can vary, most normally charge between 1-2%.
Whereas traditional asset managers levy a more-or-less fixed fee on assets under management, alternative managers can also earn a performance fee – typically 20% – on profits exceeding a specified hurdle rate. Thus, the better a fund performs in absolute terms, the more it stands to earn.
Earnings are also derived from transaction fees levied on companies that AAMs have acquired; such fees are meant to compensate the AAM for taking a firm private, restructuring or recapitalising the business, and positioning it for eventual re-entry to public markets or sale to another party. These fees can be enormously lucrative.
The shareholder of an AAM will have claim on the return from the AAM’s participation in all deals, plus the management and performance fees, less the cost of running the business[9].
Private debt
Private debt (or direct lending) describes a transaction where the lender provides a loan to the borrower without the use of an intermediary or a bank. Generally, the lender will directly originate the loan by approaching the private equity sponsors and/or owners of businesses such as commercial real estate.
The loan is typically held to maturity and the lender has the ability to assume control where there are issues relating to repayments and as mutually agreed through the lending terms with the company. Private debt loans are not rated and are typically secured by the cashflow or assets of the business, but do not amortise over the life of the loan.
How has the private debt market grown?
Institutional investors that invest in private equity programs have long included allocations to mezzanine debt and distressed debt funds. However, the hunt for yield in a low interest rate environment has fuelled growth in other types of private debt funds, particularly private debt funds that make direct, hold-to-maturity loans to businesses.
Increased regulation imposed on the more traditional banking system has created opportunities for nonbank lenders such as private debt funds. As banks have dramatically scaled back their direct lending in response to a raft of regulatory reforms, private debt funds offering very attractive risk-adjusted returns have stepped in and are filling the void.
The private debt asset class has grown to US$848 billion of assets under management[10]. The growth of the broader private debt market is supporting the growth of listed private debt funds. Listed private debt provides a liquid way to access an otherwise illiquid institutional market.
What are the advantages of private debt?
- the illiquidity premium: a return premium earned for holding non-traded debt.
- hold-to-maturity and step-in rights: non-syndicated, hold-to-maturity loans give lenders greater control in workouts and alignment with the borrower
- tighter deal terms: tighter covenants and lower leverage
- alignment with a private equity sponsor: advantage of access to “top-up” equity in times of stress
- stronger credit performance: historically middle-market loans have experienced lower loss rates vs the broader institutional loan market.
Why choose listed private debt?
In a world of sustained low interest rates listed private debt funds stand out as offering attractive yields (8-10%), floating-rate interest exposure and compelling risk-adjusted returns. The growth of the broader private debt market – which is being driven by the low interest environment and the vacuum created by the traditional lenders (i.e. banks) focusing elsewhere – is supporting the growth of listed private debt funds, particularly as broader investors also seek more liquid ways to access an otherwise illiquid ‘institutional’ market.
Compared to traditional high yielding investments such as high yield bonds, REITs and utilities, which are trading at very low yields, many of the listed private debt funds currently represent very good value.
Self-originated, hold-to-maturity, non-traded private debt assets are accessible through publicly listed vehicles -private debt funds.
What are listed private debt funds?
Listed private debt funds are funds listed on major exchanges that make direct loans to businesses, infrastructure projects, commercial properties or more specialist niche sectors such as venture capital or resource based investments.
The point of difference with the many listed credit funds is that listed private debt funds predominately invest in non-traded, non-syndicated, hold-to-maturity, self-originated loans, not highly traded credit securities such as corporate or government bonds, mortgage-backed securities, or widely syndicated tradeable debt. In so doing, they enable investors to earn an additional illiquidity premium.
What are business development companies (BDCs)?
Within listed private debt funds, the largest category of funds making direct, hold-to-maturity loans are the US-listed Business Development Companies (BDCs). The BDC model was created by US Congress in the 1980s to facilitate lending to small and middle-market companies. BDCs are regulated under the Investment Company Act of 1940.
BDCs are closed-end investment companies that typically focus on direct, hold-to-maturity loans to US middle-market private companies with EBITDA of US$10 – $100 million. A number of the BDCs focus on specialty finance niches such as asset backed finance, equipment leasing or venture lending.
The BDCs invest in directly originated loans to US middle market businesses (figure three). They offer running yields of circa 8- 10% p.a. which compare very favourably to other fixed income alternatives. The underlying senior secured loans in most listed private debt funds are generally regarded as having a credit risk of BB (i.e. sub-investment grade).
What are the advantages of BDCs?
- Private equity backed borrowers: Middle-market lenders tend to invest mostly in private equity sponsored deals. The private equity companies’ ability to provide “top-up” equity in periods of market stress offers better risk adjusted returns. Private equity backed borrowers are also less likely to default.
- Lower default rate and stronger recovery rate: vs syndicated and leveraged loans. We believe the close interaction between borrower and lender, and the ability of lenders to assume control, have been major drivers of this stronger credit performance.
- Illiquidity premium: Given that direct loans to midsized businesses are less liquid than high yield bonds or leveraged loans to larger companies, investors can expect an extra return for the illiquidity.
- Tighter covenants and lower leverage: vs syndicated and leveraged loans.
- Stronger credit performance: vs syndicated and leveraged loans.
Access to private equity, and the investable ecosystem of private market opportunities, continues to evolve and, increasingly, listed PE funds are available to investors. This creates a system where the PE firm has access to permanent capital to fund its investment activities, and one that provides investors with greater flexibility because of the liquidity that comes with a listed vehicle. In other words, listed private equity has made PE more accessible to a broader range of investors.
As well as increased liquidity, investors also have immediate exposure to a diversified portfolio of underlying companies, at varied stages of operational improvement, which better distributes the return to investors through time.
PE has typically provided better returns than those offered by listed equities, with lower levels of volatility relating to the illiquid nature of the strategy. LPE provides investors with the potential to capture the private equity return premium over time but with genuine daily liquidity. LPE does carry more market-like volatility given the daily priced nature of its listed investible universe.
Many would argue that the PE model offers a far superior governance and ownership model that underpins the PE/LPE Fund’s ability to generate these returns using, for example, the skill of the management teams, appropriate mix of equity and debt (leverage), and the better pricing available in private markets.
An increasing number of investors are looking to access PE and LPE given the potential it offers to diversify portfolios and capture a meaningful source of return on investment – which arguably is being driven by a governance model that is more conducive to planning and operating effectively for the longer term.
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