Macquarie Co-Investment Fund (MCIF)

Transcription

1 Macquarie Co-Investment Fund (MCIF) Macquarie Co-Investment Fund (MCIF) is another innovative closed end (10 year investment timeframe) private equity product providing retail investors access to segments of the market they have been otherwise previously excluded from. One of the key attractions with a co-investment fund is it gets in at the ground level and invests alongside the private equity specialist. The other advantage of this type of product over a fund-of-fund is it removes a layer of fees. Overall the structure of the product is solid, with portfolio construction ensuring a diverse blend of co-investments and direct secondaries (see fund structure for definition) across the buy-out, expansion and venture capital stages of private equity. Zenith believes the returns and diversification benefits of private equity investing are compelling and worthy of consideration. Investors do however need to be mindful of the riskier nature of private equity investing which can be hit and miss and hence should limit their exposure within a well balanced portfolio. While Macquarie s experience in direct private equity investing is limited (14 co-investments in 8 years, totalling only $13.4m), Zenith rates the Alternative Investment team (Rob Credaro, John Brakey & Michael Lukin etc) first class and is of the opinion their overall private equity knowledge and expertise in the identification and selection of private equity managers will stand them in good stead. To complement this experience Macquarie has in place an Investment Committee structure which oversees all investment decisions and comprises a private equity veteran with in excess of 20 years experience (Alex Varley ex Catalyst Private Equity & BLE Capital). A well structured product Zenith does however see some room for improvement with relation to the fee component. Macquarie s performance fee is based on total returns rather than on returns above its hurdle (10% p.a. IRR). While this precludes Macquarie from receiving a performance fee below a 10% p.a. internal rate of return (IRR), beyond this level it essentially side steps the hurdle rate through a catch-up performance fee structure (50%) on returns between an IRR of 10.0% %. The end result is that if MCIF delivers a 20% IRR the Manager will receive a 4% performance fee rather than 2% under what Zenith would regard a normal performance fee structure with a hurdle. While overall the quality of Manager, the nature of the asset class, robustness of the investment approach and rigour of portfolio construction passed with flying colours, the fee structure and limited track record of the Group in direct co-investments tempered our rating. Based on our overall assessment we have assigned an APPROVED rating to the offer and are comfortable endorsing its use in portfolios. Key Features Description Asset Class Private Equity Security Type Closed end fund Benchmark 10% p.a. internal rate of return Return Objective To outperform the S&P / ASX 300 Accum. index over the recommended time horizon Time Horizon 10 years Public Raising $20 million - $40 million Minimum Investment $20,000 Initial Payment 50% on application Second Instalment 50% on 1 st May 2006 Manager Macquarie Investment Manager Limited (MIML) Key Investment Personnel Rob Credaro & John Brakey (Division Directors) Entry Fee 3.0% + GST of committed capital Management Fee 1.5% p.a. + GST of committed capital less return of capital & any written off capital Performance Fee 20% of return above 10% p.a. Key Dates Offer Opens 11 May 2005 Offer Closes 24 June 2005 Fund Structure Macquarie Co-Investment Fund (MCIF) is the first retail offering of its kind to give individual investors the opportunity to gain access to direct co-investments and direct secondaries alongside specialist private equity managers. MCIF will pool retail investor monies before acquiring units in a wholesale fund equivalent. The wholesale fund will initially acquire between 10 to 12 coinvestments and direct secondaries. Co-investments are those in which Macquarie will invest directly alongside specialist managers in private equity investments. These typically arise where a private equity manager is unable to finance a transaction on their own and approach other investors. Macquarie has previously (not in this fund) made 9 coinvestments totalling $13.4 million with 7 external managers. Direct secondaries are opportunities to acquire investments from disengaged or disenfranchised investors. These opportunities generally arise, owing to:

2 Government institutions with shorter-term cash requirements; Founders and management that are no longer involved in the business; Investors where there has been a change in investment or corporate strategy; or Investors where regulatory changes results in the desire to sell assets (i.e. banks). These investments are usually acquired at a discount to their true value, as the interests of the sellers are generally different to those of an investor with an objective of long-term gains. The Fund will leverage of Macquarie s relationship with an investment specialist targeting direct secondaries, with which it has made 3 direct secondary investments totalling $0.1 million. Prior to the purchase of units in the wholesale fund, MCIF will hold assets in the Macquarie Treasury Fund or a wholesale cash management trust with an AAA rating. MCIF is a closed end trust which comprises a drawn down and committed component. Of the initial amount applied for, 50% will be due on application followed by an additional 50% on the 1 st May The investment life for this investment is 10 years, although this may be extended in order to exit investments effectively. Performance Analysis Deal Amount Invested ($ m) IRR (% p.a.) Deal % Deal % Deal Written Off Deal Written down to zero Deal % Deal % Deal % Deal % Deal % Deal Capital multiple 23 times Deal Capital multiple 6 times Deal % TOTAL Macquarie has a record of co-investment in private equity through investments they have made predominately through their Macquarie Alternative Investment Trust (MAIT) fund of fund range. The attached table summarises the returns achieved on these investments. While the table below highlights the high risk hit and miss nature of private equity, it should be mentioned that given Macquarie s limited capital at work, its investments have been predominately skewed towards early stage or venture capital (see portfolio construction for description of private equity sectors). This sector of the private equity market tends to be more volatile and the same dispersion of returns will not necessarily occur within buy-out capital and expansion capital which tend to be more mature, established businesses. Of the 12 Macquarie co-investments and direct secondaries the following profile of returns occurred: 4 returned double digit internal rates of return 1 (IRR); 2 were either written off or written down to zero; 2 delivered negative results; 2 were held for 1 month only and delivered strong capital return multiples 2 (22 and 6 times); 1 returned a single digit IRR; and 1 is still carried at cost; While comfortable with the track record of Macquarie s co-investments / direct secondaries, the analysis can be heavily influenced by 1-2 investments given the small sample size. Deal 1, accounts for 35% of the total amount invested and for 57% of realised / unrealised gains. As a consequence this investment has a large bearing on a money weighted internal rate of return calculation, reported at 42.6%. While private equity investing is a 5-7 year proposition in Zenith s opinion, it is interesting to note that the three realised investments which delivered the strongest results (i.e. double digit IRR returns) all had short investment timeframes: Deal 8 14 months; Deal 1 Deal 7 15 months; and 8 months. In this case, Deal 8 was a buy-out having been spun out of the private hospital division while Deal 1 and Deal 7 where expansion stage private equity investments. Our analysis shows that it can often be the case that in private equity the winners are out early and those 1 Internal rate of return The rate of return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity. 2 Multiple of Capital a ratio usually greater than 1 the multiple achieve on capital invested.

3 which don t realise their full potential tend to have longer work out periods. Investment Personnel Name Alternative Investments Team John Brakey Michael Lukin Greg Little Frewen Lam Alternative Investment Committee John Brakey Rob Credaro Virginia Malley Alex Varley Macquarie Bank Group Responsibility Division Director & Head of Alternative Investments Associate Director Manager Analyst Director Director Director Independent Director While the Macquarie Co-Investment Fund is the Group s first retail product which specialises in coinvestments and direct secondary investments, the Manager began investing in private equity in 1996 and currently manages / advises on approximately $1.6 billion of commitment in this asset class. Macquarie Investment Management Ltd (MIML) MIML acts as both Manager and Responsible Entity (RE) to the Offer. As Manager, MIML is responsible for advising MCIF on the management of its portfolio, primarily by recommending co-investment and direct secondary private equity investments. Alternative Investment Committee (AIC) Sitting outside the Alternative Investment team but still actively involved in private equity within the Group is Robert Credaro. A division director of MIML, CEO of the listed vehicle, Macquarie Private Capital Group (MPCG) and member of the Investment Committee, Credaro is rated highly by Zenith and regarded as an important ingredient within Macquarie s capability in this asset class. While Macquarie has been one of the early pioneers and remains a significant player in fund of fund private equity investing, its co-investment experience is limited. To further bolster its direct private equity experience Macquarie utilises the experience and expertise of Alex Varley, a member of the investment committee who has over 22 years industry experience (ex Catalyst Private Equity, BLE Capital). Other members of the Investment Committee include Virginia Malley, who is Head of Risk Management at MIML and John Brakey. The AIC s role is primarily to review investment recommendations and to ensure that the investment process has been rigorously adhered to by the alternative investments team. The minimum quorum for meetings of each AIC is three of the four members Alternative Investments Team Within MIML sits the Alternative Investments Team, which drives the analysis of investment opportunities, further detail is given below on members of this team. The Macquarie Alternative Investment team consists of John Brakey, Michael Lukin, Greg Little and Frewen Lam. John is the Division Head of Alternative Investments, the portfolio manager responsible for MCIF and a member of the Investment Committee. He has over 13 years investment and private equity experience. Prior to joining MFM, John worked as an asset consultant specialising in the assessment of private equity managers for Towers Perrin. During his time at Towers Perrin, John was responsible for the due diligence of the private equity managers included in the Federal government s Innovative Investment Fund (IIF) programme. He was also a member of the Towers Perrin Alternative Investment Committee supervising portfolio construction for client s alternative asset portfolios. John has been supported for the last four years by Michael Lukin in the position of Senior Analyst. Michael has been responsible for the development of a number of quantitative tools used in providing advice on investment strategy and manager selection. He is also responsible for the management of investment research projects within the team. Prior to joining MFM, Michael spent over three years as an asset consultant with Towers Perrin. Michael s responsibilities included working with the Alternative Investments Group of Total Risk Management, a subsidiary of Towers Perrin, on alternative manager selection and policy. Michael was involved in the review of private equity fund of funds and private equity managers for the federal government s second IIF program. Greg Little is the third member to join Macquarie s alternative investments team (having joined in August 2004). Greg is directly involved in the due diligence and analysis of investment decisions within the Alternative Investments team having joined Macquarie from Pacific Corporate Group LLC (PCG), a private equity advisory and funds management firm based in the US. During his 4 year tenure at PCG Greg was involved in all aspect of due diligence and is seen as a strong addition to the team given his international perspective and mature private equity market experience. Frewen Lam is the final and most recent member to join Macquarie s alternative investments team (having joined as a graduate in January 2005). His responsibilities principally involve managing the administration of funds / Investment Management Agreements (IMA s) including unit pricing and performance calculations. Operating a four person team (up from 2 people only 2 years ago), Zenith is confident Macquarie has the

4 necessary resources to undertake co-investment due diligence which is typically more intensive and time consuming analysis than fund-of-fund work. While each team member has distinct responsibilities, portfolio decision making occurs under a collegiate approach, with ultimately responsibility falling to John Brakey. In our view, there are very few managers with an investment team capability to match the experience and expertise of Macquarie. Furthermore operating a bottom-up approach lends itself to an easier transition in the co-investment sector. Investment Process The Macquarie Alternative Investments team applies a multiple stage investment process to the selection of appropriate private equity investments suitable for MCIF. This process begins with a forward looking assessment of the market that seeks to identify future capital raisings by managers. The key outcome from this step is to produce a blueprint for portfolio construction that identifies appropriate co-investments / direct secondaries and their timing for raising capital. The possible manager universe comprises around 120 managers however the private equity team are able to filter this down to around managers quickly based on broad criteria such as the assessment of management and past performance. From this list Macquarie maintains ongoing relationships with over 15 private equity firms, which it expects will provide the source of co-investment / direct secondary opportunities. The team focus its analysis on those managers that have previously generated top quartile returns. In the initial stages of investment, the team focus on identifying the management buyout (MBO) and expansion stage managers first. The early stage and special situations private equity managers are considered later for inclusions in the portfolio. The reason for this is that the MBO and expansion stage managers tend to be less risky investments than the early stage or special situations managers because they are investing in businesses that are already established and are more advanced in their life cycle. As a result, they will generally not provide the same levels of returns that an investment in a riskier early stage or special situations business may produce. Once a manager has announced its intention to raise capital, the private equity team will review and document relevant details from the information memorandum provided by the manager. Manager & Co-investment Selection The Macquarie Alternative Assets team has developed a thorough set of criteria (see below for details) used for the analysis and assessment of private equity fund managers and prospective co-investments. In addition, the team has built up an extensive network of contacts within private equity management that assists them to keep up to date with the latest industry developments. The evaluation process is ongoing but formally starts with a review of market references of the people involved before visiting the manager s office for a full due diligence assessment. This process focuses on assessing the manager s: Management team experience; Ability to support their underlying investments; The organisation s strengths and weaknesses; Investment and assessment process applied; Investment structuring experience; Value adding strategies; Exits from investments; Financial position; Business plans; Investee company reference checks; Characteristics considered key criteria for underlying co-investments include: History of the Company including reasons behind the investment opportunity, nature of the existing / new shareholders, broad description of the business; Industry and Market Overview including key competitors, service providers, key risks for the industry; Management including extended due diligence on the management team, industrial relation issues, nature of the workforce, key HR risks; Strengths and Risks of the Business; Financial Analysis historical and projected financial information (P/L, Balance Sheet); and Deal Structure & Valuation including industry & competitor valuation comparison, equity structure, ownership structure, exit strategy. Where possible the Macquarie Alternative investments team seeks to take a position on the Board of the underlying co-investment to help ensure that the interests of the MCIF investors are properly met. In addition, the team are very proactive in attempting to add value by providing input on company strategy, developing information systems and the adoption of internal performance monitoring systems. Where a co-investment or direct secondary meets the team s investment criteria, it is then put forward as a recommendation to AIC. The Alternative Investment Committee s role is primarily to review investment recommendations and

5 to ensure that the investment process has been rigorously adhered to by the alternative investments team. The minimum quorum for meetings of each AIC is three of the four members. If an investment is approved by the AIC the investment team then advance to the negotiation of the investment terms on the co-investment / direct secondary. Macquarie insists on the same investment terms as the private equity manager on any coinvestment. The investment team will draw upon the extensive resources of MIML s legal counsel to assist in the structure and content of all legal agreements. The critical issues focussed on within the negotiation and legal agreement process includes: Deal structure; Key person provision; Fees (both base and performance); Investors right to terminate manager; General investors rights; Set investment period; Non-competing funds; Once MCIF has invested in a particular co-investment / direct secondary, MIML conducts formalised monitoring and review of the underlying investments which is then passed onto MCIF via a monthly report detailing information on the status of the portfolio. MIML tends to be formally involved in quarterly updates with the managers, in addition to contact on an ongoing basis at the underlying investment level. As a result the investment team will have an intimate understanding of the MCIF underlying portfolio of investments and their performance. From a quantitative perspective, MIML has built an extensive manager database that is kept up to date with fund manager performance, details of their capital raisings and underlying portfolio details. In addition to the manager data, MIML tracks all underlying investments (including valuations), which is updated on a monthly basis. Portfolio Construction MCIF is a unit trust of pooled retail investor monies which will acquire units in a Wholesale Fund. Prior to an investment in the Wholesale Fund the MCIF portfolio will comprise units in the Macquarie Treasury Fund (or an equivalent AAA rated wholesale cash management trust). As the Wholesale Fund makes calls to fund purchases of co-investments or secondary transactions, cash units will be sold and the proceeds used to fund these calls. During the period in which the MCIF holds cash units (initial 0 2 years), distributions are expected to be regular. As MCIF invests and cash units are sold distributions are expected to become less frequent with the possibility that in some years no income distribution will be made. Once fully invested the portfolio is expected to comprise between co-investments and direct secondaries. Macquarie s blueprint for portfolio construction focuses on maintaining a well diversified portfolio. That is, the Manager aims to construct a portfolio that is well diversified by the number of investments and private equity category. The portfolio s category constraints ensure that the majority of the portfolio is invested in the less risky categories of expansion capital and management buyouts. That is, up to 100% of the portfolio may be invested in these categories while the level of investment in the riskier categories of venture capital is more tightly restricted to 30% of the portfolio. The following definitions explain the differences between the three traditional private equity categories MCIF will invest in. Buyout stage - the purchase of what is normally a majority stake in an established mature asset with reliable cash flows, low operational risk and a strong market position. Early stage or Venture Capital stage specialise in providing seed capital and have strength in assessing and commercialising new technologies (i.e. sectors such as IT, biosciences etc). Expansion stage typically provide additional capital to established companies which require funding to expand product / service. Risk Management Category Constraints Investment Ranges Allocation Guidelines Expansion stage 30% - 50% Buy-out stage 30% - 50% Venture capital stage 10% - 30% No. of Investments Expansion stage 3-6 Buy-out stage 4-8 Venture capital stage 4-10 Other Constraints Direct secondary investment <30% Macquarie group related deals <10% Non-$A denominated investment <20% % of MCIF any single company <20% While the portfolio construction guidelines provide adequate asset allocation diversification, MCIF also has some additional risk management constraints in place. A maximum exposure of 30% to direct secondaries ensures portfolio diversification of investment style. A maximum 10% allocation to Macquarie related deals should provide investors with a level of comfort that the fund cannot be used as a dumping ground and loaded up with internally sourced deals. The maximum 20% exposure to non $A denominated investments ensures the fund remains domestically

6 focused, which in Zenith s opinion is where the expertise and access to deal flow sits within the Alternative investments team. With no more than 20% of the portfolio permitted in a single company the single asset risk is constrained. Other constraints Zenith would like to see added include: No more than 25% of the fund s final portfolio will be invested with sector specialist managers (used in other Macquarie product) 3 ; and A maximum exposure to assets sourced from a single manager. We believe the risk management constraints applied to the MCIF portfolio are both rigorous and consistent with the manager s approach of maintaining a well diversified portfolio. While some of the constraints appear quite broad, we believe this is necessary given the opportunistic nature and timing of the underlying asset classes invested in. Fees A contribution or entry fee of 3.3% of an investor s committed capital, inclusive of GST, is deducted from application monies. Up to 100% of this fee may be paid to an adviser as upfront commission. Advisers may forgo this fee in whole or in part and rebate to the investor. This fee will not be rebated to clients who do not have a financial adviser. The Manager (MIML) is entitled to a Base and Performance Fee. The following base fee is payable quarterly in advance: 1.65% p.a. (inclusive of GST) of committed capital less return of capital and any written off capital. While a base management fee on committed capital is often the norm in private equity, it provides the Manager with a free kick on fees before the money is drawn down. Private equity managers argue that the majority of the due diligence work is undertaken before the money is invested and therefore the fee is justified. They also often point out that a fee based on when the money is drawn down incentivises the manager to invest quickly rather than in the best opportunity regardless of when it arises and aligns manager and investor interests. We would argue that this is achieved by introducing a performance fee component. Either way Zenith is of the opinion that getting paid 1.65% for managing investor monies in the Macquarie Treasury Fund, where the normal MER is 0.44% and for 50% of the application amount not yet called (1 st May 2006) is excessive. Once capital is returned to investors via distributions, it is deducted off the base management fee but remains loaded at the front end. The following performance fee is payable: Paid up capital distributed fee; % IRR nil performance fee; nil performance 10.0% -16.6% IRR 50% performance fee catch-up ; and Above 16.6% IRR 20% performance fee. The performance fee is attached to realised gains and after the initial paid-in capital and a minimum 10% per annum return has been paid to investors. While at first glance the hurdle rate looks attractive, the key wording is Macquarie will be entitled to receive a performance fee of 20% on total returns. The normal practise when a hurdle rate exists is the performance fee is attached to any return above this rate. While the positive is the structure excludes Macquarie from being paid a performance fee below a 10% IRR, the negative is should it achieve a rate of return beyond this level it essentially takes back what it has previously given up and side steps the hurdle rate through a catch-up clause. For example based on an IRR of 20% p.a. (which is what Macquarie targets internally) the Manager is paid a performance fee of 4.0%. Under a 20% performance fee structure based on returns above a 10% IRR this would equate to 2.0%. The following additional costs may also be incurred: Administration costs administration & other fees charged by the product issuer, distribution costs and other expenses. Ongoing costs of running MCIF are estimated at $50,000k per annum; and Private equity manager fees paid by the wholesale fund for sourcing co-investments, may be in the form of a base management fee or performance fee. While the fund currently allows for this fee provision, MIML has indicated that it does not envisage these fees to be triggered. Should MIML be removed as Responsible Entity of the Fund when not in breach of its obligation under the constitution, it is entitled to a base management fee for the 1 year and a performance fee based on disposal of assets on the date of its removal. One of the key attractions on a co-investment fund is it typically removes the double dip on fees. That is the fund invests alongside the private equity specialist and therefore the first layer of management / performance fees are typically avoided. 3 These are managers who specialize in or concentrate on a narrow industry such as bioscience or IT.

7 Risks of the Fund There are specific risks attached to investing in private equity. As many of the underlying companies are still relatively small and in the early stages of their development, the failure rate is higher than that of larger, more established companies. Investors should note however, that it is these very attributes of private equity that provides the potential to achieve above share market returns. In addition, MCIF s focus on investing a greater proportion of the portfolio in expansion stage and / or buy-out companies reduces the overall risk of the portfolio. Other specific risks attached to this Offer include the following: Liquidity risk the investment time horizon on the Fund is 10 years, the product structure is closed end and no liquid secondary market exists; Investment risk risk that the Fund fails to deliver acceptable returns, risk that the Fund cannot source appropriate investment opportunities; Funding risk the ability for MCIF to fund uncalled / undrawn commitments; Timing risk lead time on being fully invested, known as the j curve effect in private equity; General market risk i.e. health of private equity sector. Effects identification of opportunities and ability to realise existing investments (i.e. typically via an IPO); Manager risk ability to identify quality private equity managers which will in turn bring co-investment opportunities to MCIF; Diversification risk that the MCIF portfolio remains diverse to reduce excess exposure to a single sector of the economy / market and / or exposure to a single investment; Funding risk the ability for MCIF to fund uncalled / undrawn commitments; Timing risk long lead times on being fully invested in private equity and on realisation of investment; Valuation risk the Manager is reliant on valuation information from each of the specialist managers; and Currency risk that the Fund s non-australian denominated investments (max. 20%) will be exposed to exchange rate fluctuations. The risks outlined above are not exhaustive and other factors not mentioned above may materially affect the future performance of the Fund. Applications of the Fund Unlike most unlisted institutional private equity fund structures, MCIF is not a fund of fund and therefore avoids a layer of fees normally attached. The fund gains its entry into private equity investing at the ground level alongside private equity specialists. One of the draw backs on this style of private equity investment is its illiquid nature this is a closed end product with an investment timeframe of 10 years. The long term nature of private equity investment will also result in the returns from MCIF typically being of a capital gains nature rather than investment income. The exception to this rule is in the formative years before committed capital is drawn upon and sits in the Macquarie Treasury Fund or a wholesale cash management trust equivalent with an AAA rating. In our view, private equity has arrived as a major component of any alternative investment universe and is now more broadly accepted as an established asset class. Zenith believes that private equity investing should be strongly considered by investors as historical analysis has shown it can improve the risk / reward characteristics of a portfolio. Some of the reasons for investing in private equity are briefly detailed below: 1. Long term historical out-performance the international experience supports the view that private equity offers a premium above listed equities albeit within a different risk profile; 2. Absolute return focus whilst many managed funds now engage in closet indexing, MCIF seeks an absolute 10% p.a. return objective and has an incentive structure geared towards this goal; 3. Portfolio diversification private equity can further improve diversification and whilst its correlation with listed equity remains hotly debated, in Zenith s opinion it is comfortable with the merits of its inclusion as an asset class in portfolios; and 4. Stocking picking focus given private equity funds often take large / controlling stakes in companies, few funds have access to the same companies and therefore their skill in finding investment opportunities is reliant on true stock picking skills. The nature of private equity, i.e. its growth potential focus, also supports this view. Given that private equity is in essence unlisted equity we are of the opinion it should sit as part of the equity asset class within a portfolio. Investors need to be mindful however of the riskier nature of private equity investing which can be hit and miss and hence should limit their exposure within a well balanced portfolio. Author: David Smythe Director Zenith Investment Partners david.smythe@zenithpartners.com.au Ph: (03) , Fax: (03) DISCLAIMER: This report is prepared exclusively for clients of Zenith Investment Partners (Zenith). The report contains

8 recommendations and advice of a general nature and does not have regard to the particular circumstances or needs of any specific person who may read it. Each client should assess either personally or with the assistance of a licensed financial adviser whether the Zenith recommendation or advice is appropriate to their situation before making an investment decision. The information contained in the report is believed to be reliable, but its completeness and accuracy is not guaranteed. Opinions expressed may change without notice. Zenith accepts no liability, whether direct or indirect arising from the use of information contained in this report. No part of this report is to be construed as a solicitation to buy or sell any investment. The performance of the investment in this report is not a representation as to future performance or likely return. The material contained in this report is subject to copyright and may not be reproduced without the consent of the copyright owner. Zenith usually receives a fee for assessing the fund manager and product(s) described in this document against accepted criteria considered comprehensive and objective.