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NEWS - FINANCE
Private equity
7/15/2002
Savvy investors who know that stockmarket turbulence is a fact of life are looking at more attractive "alternative" areas of investment. One of these is private equity - interesting because of its diversification, different perspective and returns.
Whether it's via a stockmarket-listed company or fund or an unlisted fund, private equity is all about investing in a portfolio of promising small to medium-sized, privately owned companies that want to get bigger, explains Steve White, a principal with Sydney private equity fund manager Quay Partners.
Private equity offers opportunities for astute and patient investors to earn above-average returns, on condition they take a genuine medium to long-term view with regard to the money allocated to private equity. A return of between 15 and 20 per cent a year is the widely quoted expectation from a private equity portfolio.
The returns come from a combination of buying promising private companies with growth potential and then encouraging them to grow and develop before selling them. Integral to the process is adding value before either floating the businesses on the stockmarket or selling them for a profit to larger investors in what are described as trade sales.
For many small businesses, private equity ownership represents a stepping stone - a sort of halfway house between small business and the stockmarket. Companies that have gone through this process include Neverfail Springwater, Energy Developments, Miller's Retail and Cellnet Telecommunications.
Prominent companies presently reliant on private equity investors include Australia's third-largest car rental business, Europcar, the JB Hi-Fi and Reject Shop retail chains, the Repco auto parts business (spun out of Pacific Dunlop in a management buyout funded by private equity) and the Funeral Homes business bought in a similar way from its American owner last year.
But to expect such returns requires full knowledge of what you're getting into, given they are higher returns than the long-term 12 to 14 per cent delivered by more traditional share investments. Many are also higher-risk investments, especially businesses where there is more blue sky in terms of potential.
"What well-managed private equity investing offers is a premium return to ordinary share investing," says David Shields, head of private equity at Deutsche Bank.
But there is an important trade-off: extreme patience. It's not like ordinary share investing, where many investors have return expectations - in terms of either dividends or capital growth - from the moment they commit their money.
With private equity investing, it takes time to develop the underlying assets so that they can be sold for a profit. They are genuinely long-term investments.
This is reflected in the fact there is no automatic market for investor interests in unlisted private equity funds. They are illiquid investments.
Holdings in listed private equity entities - which includes the special category of tax-concessional pooled development funds - can be bought and sold through the stockmarket. But the profits won't be there until the investments have had time to develop and perform.
During the period of ownership, the assets are hopefully on a steep growth curve with income being pumped back into the businesses to encourage additional growth or repay debts. This is why private equity offers a totally different pattern of investment returns.
A portfolio of private equity investments in an unlisted fund should be able to outperform a broad sharemarket accumulation index by at least 5 per cent over 10 years, reckons Steve Baldwin, head of private equity at Colonial First State. But it will be a lumpy return rather than a smooth one, he says.
An appropriate index is the S&P/ASX200, the S&P/ASX300 or the ASX All Industrials. Where the private equity portfolio is in a sharemarket-listed fund, a realistic return expectation is between 3 and 5 per cent of the top 200 or the Industrials Accumulation Index over the long term, estimates Baldwin. Colonial First State has both unlisted and listed private equity investments.
While many private equity investments may be relatively new businesses, others may be subsidiaries of public companies that want to go private, often through a management buyout, says Quay Partners' White. In both cases the business needs the help of private equity funding to grow.
The skills offered to investors by managers of unlisted private equity funds (for which they are very well paid via management fees plus generous profit-sharing incentives) is the ability to come up with deals and then filter them for the best ones. In the listed market, where managers need the same basic skills, they are often sizeable shareholders and get their extra rewards via personal equity interests.
Patrick Elliott, executive director of Macquarie Direct Investments (which is offering an unlisted private equity fund seeking to raise $150 million from investors by July 31), says the aim of private equity investing is to buy quality private businesses at relatively low prices. You may pay a multiple of six to seven times the annual earnings. During the period it is being bankrolled, the business is worked and managed hard and hopefully improved with the aim of at least doubling the earnings.
When the investment is realised, either through a public float or a trade sale, investors hope not only for a price improved by the higher earnings but also from being able to ask a higher price-earnings multiple of, say, 12 to 13 times. This is most likely where the business is floated on the stockmarket.
Elliott says there are three distinct categories of private equity investing.
There is early stage investing, often associated with biotechnology and information and internet technology investing. This is pioneering venture capital investing. It offers high potential return but is also higher risk - so much so that some managers put limits on their involvement in this category because of the real prospect of business failure.
The second category is investing in businesses with a track record and with customers. Their main need is expansion capital. These investments don't carry the same start-up business risk. The strategy and risks are those associated with trying to turn a small, profitable business into a big profitable one. Many private businesses don't have the assets, such as property, against which most banks lend money for growth, says Elliott. At the same time, they have exhausted the capital the owners, their family and friends have contributed. To fund the next stage of growth requires a private equity contribution.
The third category is mature businesses, where the help required is often money to allow a management team to buy the business from a major private shareholder or public company owner. Elliott says a good example is the Funeral Homes cemetery and crematorium operations of US company Service Corporation International. With the help of private equity, the local management team last year organised a combination of debt and equity to buy the business. Such businesses often have strong cash flow that goes towards reducing debt and building up equity value.
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