CPD: The case for listed private equity – Part 3

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Allocation to private equity can add value to investor portfolios.

This article from PAN-Tribal Asset Management is the final 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. The second article examined the types of private equity investments. This final article takes an in-depth look at the characteristics of private equity and listed private equity and examines its role in investor portfolios.

Private equity (PE) is the ownership of, or an interest in, a corporate entity that’s generally not publicly listed or traded. PE managers tend to raise capital from high-net-worth individuals or institutions into PE funds; they 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 vehicles can be listed or unlisted. Listed Private Equity (LPE) encompasses listed entities whose main activity is investing in private companies, private equity funds or the investment managers of private equity funds.

PE and LPE provide diversification benefits when used as part of an investment portfolio and many successful global investors have substantial allocations to private equity (figure one). Both PE and LPE can provide investors with exposure to an investment universe that sits outside of the types of businesses that underpin traditional asset class options, such as companies in the earlier stages of their growth lifecycle that are private companies not listed on public stock exchanges. This is particularly relevant given an increasing number of companies are ‘staying private for longer’ and investors should consider how they can access that growth opportunity.

What is private equity?

All companies start as an idea on a piece of paper and can grow into billions of dollars of revenue. Along the way there will inevitably come points in the companies’ lifecycle where they will require access to capital and there will be specific types of investors that can help them along each step of the way (figure two).

Private equity (PE) is simply a funding stage available to certain types of businesses – and not just exclusively to private companies. Increasingly, public companies now have meaningful PE backing.

PE is typically synonymous with investment funds that buy and restructure companies that are not publicly traded, with PE often considered as its own specific asset classes consisting of equity securities and debt. However, as the market has evolved the term is now also used to describe the business of taking a company into private ownership in order to restructure it before selling it again at a hoped-for profit.

A PE investment will generally be made by a PE firm, a venture capital firm or an angel investor. Each of these stages of investment has a set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership[1]. This is important to understand, as PE is not just a source of funding for a company – it is also about making an average company a better company and unlocking greater value for the business owners and the investors.

Why consider private equity?

Global private equity assets under management grew to an all-time high of US$6.0 trillion in 2020[3]. This century, it has grown by 8 times – twice as fast as public market capitalisation. As a result private markets have graduated from the fringes of the global economy to the mainstream[4].

PE allocations have increased in recent years, a trend that is expected to continue. This is supported by the continued attractive performance of PE generally, which has outpaced other private markets asset classes and most measures of comparable public market performance3.

A confluence of factors have combined to create strong tailwinds for the PE industry and the attraction of PE as a standalone asset class for investors. These are the:

  1. trends in private markets versus public markets, including the shrinking public markets phenomenon, growth opportunities for investors in private markets and the ‘staying private for longer’ trend
  2. market factors, such as ongoing near zero interest rates, elevated valuations in equity markets and lacklustre fixed income markets
  3. the performance characteristics of PE
  4. growth in PE assets under management.

What are the performance characteristics of private equity?

The hunt for yield in a sustained low interest rate environment has fuelled investor appetite for return seeking – with PE and private debt seemingly filling that void.

What is it about the PE model that has enabled it to generate strong returns on invested capital over long periods? Consider a private company’s partnership with a PE-backer as a ‘relationship’. One can make the case that the PE model is a far superior governance model – as there is a genuine alignment between the PE-backed company and the PE owners/management. PE managers tend to have representation on the board, remain in very close communication, and operate a remuneration model far more aligned to value creation.

Good PE firms that can affect significant transformational change on these underlying companies are capable of generating attractive multiples on invested capital. The attractive nature of the return potential from PE has been a significant driver of the growing investor demand and inflows into this alternative asset class.

What diversification benefits does private equity provide?

PE has diversification benefits when used as part of a broader investment strategy. It does so by providing investors with exposure to an investment universe that sits outside of the types of businesses that underlay the traditional asset class options – for example, companies in the earlier stages of their growth lifecycle and that are private companies not listed on public stock exchanges.

There are also sectors and regions where PE is able to provide better access relative to listed equity markets– for example, industries such as consumer facing businesses, Healthcare and Information Technology.

Private-market investing has its challenges though. Direct investments in private companies and in private equity funds require:

  • large capital outlays
  • long lockup periods, and
  • investors taking a concentrated, illiquid exposure to a small number of private companies – which are often leveraged.

PE management fees can also be significant.

Access to PE investing has been evolving over many years, particularly as broader investors develop interest in this asset class. Many investors don’t share the same capacity to own illiquid, long term PE investments. Also, a lot of investors simply don’t have the capital required to meet the minimum investment levels for PE opportunities.

An example of this evolving landscape is the notable growth in the Listed Private Equity (LPE) universe. Publicly traded entities that invest in privately held businesses, and PE-backed listed companies, are an attractive gateway for broader investors to access the diversification and risk/reward characteristics of PE. They are liquid, regulated, diversified, and easily investable[5].

What is the role of a private equity manager?

Blackstone Group (BX), Apollo Global Management LLC (APO), Carlyle Group (CG) and Kohlberg Kravis Roberts/KKR & Co. (KKR) are some of the bigger PE firms globally. Referred to more commonly now as alternative asset managers given they have diversified beyond just PE, into other alternative assets like hedge funds, real assets such as property and infrastructure, and private debt/credit.

Many PE managers have become more specialised with firms often focusing on specific industries, sectors or aspects of the businesses lifecycle. Often the PE firm brings with them a broad range of skills, resourcing 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 specialist skills can be leveraged to benefit the strategy and direction of the company the PE manager is backing.

What is listed private equity?

Currently there are over 200 Listed Private Equity (LPE) entities and over 500 PE-backed listed companies. The combined market capitalisation of these LPE entities is approximately US$2,750 billion. Almost a third of these companies are domiciled in the UK, while Europe and the US account for the remainder. The sector includes listed entities that specialise in some, or all, stages of PE investing, including:

  • buyouts, including leveraged and management buyouts
  • expansion or growth capital
  • venture capital
  • distressed or special situations
  • mezzanine capital
  • secondary investments
  • fund of funds, and
  • private debt.

This opportunity set was explored in detail in article two of this series.[6]

Typically a company will specialise in one of these investment strategies and will often limit their focus to certain geographic regions. In addition, PE and Alternative Asset Managers have, in recent years, listed their firms on public stock exchanges which has allowed a broader range of investors to own their shares and benefit from the economics of managing alternative assets.

Why choose listed private equity?

LPE provides investors with PE returns, but with public market liquidity. It is also an inefficient market, so alpha (or additional performance through manager skill) can be generated from the active management of this universe.

There is also evidence to support that:

    • PE outperforms public markets over the medium term[7]
    • LPE net asset values (NAVs) perform similarly to traditional PE[8][9]
    • Investor returns are ultimately driven by NAV growth
  • Inefficiencies in the LPE market arise from information asymmetry, lack of broker research coverage and a lack of attention from institutional investors

How does listed private equity diversify its exposure to private markets?

Traditionally only the largest institutional investors have had the resources to build out a diversified portfolio of PE funds, and even then it can take years to achieve. Whereas investments in LPE tend to be globally diversified across funds, strategies and vintages – which specifically refers to the year in which the PE fund makes the first investment.

Unlike investments in traditional asset classes, the commitment to a PE limited partnership fund is gradually drawn over the investment period (anywhere between three and five years) and does not require an upfront investment of the entire amount. However, a portfolio of LPE securities can provide an instant portfolio of private equity interests – diversified by geography, deal stage, vintage year and manager[10].

LPE diversifies investors across a number of areas including:

  1. vintage exposure
  2. sector exposure
  3. geographic exposure.

(1) What is vintage exposure?

Vintage exposure refers to the year in which a fund began making investments or, more specifically, the date in which capital was deployed to a particular company or project. Unlike investments in traditional asset classes, the commitment to a PE fund is gradually drawn over the investment period (anywhere between three and five years) and does not require an upfront investment of the entire amount[11]).

What is significant about Vintage exposure is that investments in unlisted PE funds, can experience what is known as the ‘J-Curve’ effect. This refers to a phenomenon whereby an initial investment in a PE fund stagnates for two to three years before (in an ideal scenario) appreciating. It can take time for general partners to deploy capital and for investments to pay off. Meanwhile, management fees eat into the principal.

A LPE fund, on the other hand, can reduce this effect because the underlying portfolio will typically comprise a range of existing investments that are at differing stages of maturity (much like a secondary transaction).

(2) What is sector exposure?

Sector exposure refers to different types of LPE investments, for example:

Buyouts/Venture/Growth Capital: A buyout refers to an investment transaction where one party (e.g. a PE firm) 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.

The transaction often takes place in situations where the purchaser considers a firm to be undervalued or underperforming and has the potential for improvement operationally and financially under new ownership and control. Like any other investment, a buyout will take place when the acquiring party believes that there is an opportunity of making a good return on their investment. Some companies may have the end goal of making themselves a target for a buyout offer, whether it’s by a PE firm or a competitor. For other companies it may be the unintended consequences of poor management, or an unforeseen opportunity that arises. Its source of return is generated mainly from earnings growth of underlying portfolio companies (leading to NAV growth).

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.

Alternative Asset Managers: An asset manager that manages alternative assets. Alternative assets include PE, venture capital, real assets (e.g. property and infrastructure), hedge funds, commodities, derivatives and private debt. Its source of return is generated mainly from management fees and performance fees, however it may also hold a balance sheet of investments on which returns are generated.

Private Debt: Private debt is a transaction where a lending source directly provides a loan to the borrower without the use of an intermediary. This is facilitated by the lender working directly with the PE sponsor or owner/operator of a middle market company, commercial project or commercial real estate. Its source of return is generated mainly from loan interest / coupons.

Often the various sectors within LPE are in different parts of the private equity – and perhaps broader economic – cycle, which reinforces the benefits of being able to selectively diversify in these areas.

(3) What is geographic exposure?

Geographic exposure refers to the underlying countries where the investments are domiciled. LPE comprises entities listed on international stock exchanges whose main activity is investing in private companies or PE funds. The majority of the attractive opportunities are found in North America and Europe.

How can investors access LPE?

Strategies in private assets, especially LPE, present good opportunities for investors who are keen to seek greater diversification and greater potential sources of return in their investment portfolio.

“Publicly traded vehicles that invest in privately held businesses are an attractive gateway to private markets. They are liquid, regulated, diversified, and easily investable. They help investors avoid post-commitment declines typical of PE investments. LPE provides an access point to the asset class for retail investors as well as institutions”[12].

While the LPE universe continues to grow and evolve it is important to acknowledge that these entities are not well covered by the broader research community, whether it be stockbrokers or funds management organisations. There are only a few specialist PE firms and global equity fund managers who have identified this investment opportunity and spend 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 opportunities.

Needless to say those funds management firms that pursue these investment opportunities do tend to be active, research driven funds management organisations.

An ‘In Summary’ role of listed private equity in investor portfolios

LPE has diversification benefits when used as part of a broader investment strategy. It does so by providing investors with exposure to an investment universe that sits outside of the types of businesses that underlay the traditional asset class options.

There are also sectors and regions where PE is able to provide better access relative to listed equity markets – for example, industries such as consumer facing businesses, healthcare and information technology.

As well as these diversification benefits, PE has demonstrated an attractive return profile over many years, relative to public equity returns. The PE model provides a far superior governance and ownership model, which allows the PE managers to take a genuine and strategic long-term view to execute on value creation and maximise returns on capital for PE fund and LPE investors.

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.

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.

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.

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.

 

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Read the full series:

CPD: The case for listed private equity – Part 1 – Listed versus private companies

CPD: The case for listed private equity – Part 2 – Types of listed private equity investment

CPD: The case for listed private equity – Part 3
 

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References:
[1] Trucrowd, Private Equity Financing, 2016
[2] Firstlinks, The ‘six or out’ VC approach to portfolios, 2019
[3] Prequin, ‘Dry Powder’, September 2020
[4] McKinsey & Company, Private markets come of age, 2019
[5] JANA Investment Advisers Pty Ltd, MyConsultant, 2016
[6] See: https://www.adviservoice.com.au/2021/09/cpd-the-case-for-listed-private-equity-part-2-types-of-listed-private-equity-investment/
[7] Preqin Global, Private Equity & Venture Capital Report, 2019
[8] Harris, Jenkinson & Kaplan in Journal of Investment Management, How do Private Equity Investments Perform Compared to Public Equity?, 2015
[9] Matthias Huss, Performance Characteristics of Private Equity, 2005
[10] Morningstar, Where Public Meets Private: Accessing Private Markets Through Listed Equities, 2020
[11] Salman Shah & Chen Liangzi on The Business Times, Diversifying your portfolio with private equity, 2019
[12] Preqin Global, Listed Private Equity – Opportunities for Institutional Investors, 2012
Important information: While every care has been taken in the preparation of this document, neither Barwon Investment Partners Pty Limited ABN 19 116 012 009 AFSL 298445 nor PAN-Tribal Asset Management Pty Limited ABN 35 600 756 41 AFSL 462065 make any representation as to the accuracy or completeness of any statement in it, including without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document has been prepared for use by sophisticated investors and investment professionals only and is solely for the use of the party to whom it is provided.

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