Private Equity WHITE PAPER

Transcription

1 Private Equity WHITE PAPER

2 Contents Introduction 3 An introduction to the asset class 4 Risk and return 15 Private equity in a broader investment portfolio 24 The European private equity market 27 Manager universe and fund characteristics 34 ESG and responsible investment 36 Conclusion 39 Bibliography 40 Kempen Private Equity Should you have any further questions about Private Equity at Kempen, please contact us. Sven Smeets sven.smeets@kempen.nl Edzard Potgieser edzard.potgieser@kempen.nl Marvin de Jong marvin.dejong@kempen.nl Bram Bikker bram.bikker@kempen.nl KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 2

3 Introduction The aim of this white paper is to examine the characteristics, opportunities and advantages and disadvantages of private equity. We look at the European private equity market in more detail, for illustrative purposes. In this way we expect to contribute to a balanced discussion of this asset class. Private equity had a strong rise in the 1980s and 1990s and has since become an established asset class. Its image is strongly dictated by high-profile cases reported by the media, such as the stock market flotations of companies such as Snap and Twitter. Yet a large portion of the private equity market operates below the radar. One of the world s largest venture capital exits of 2015 passed relatively unnoticed, for instance. This concerned the sale of Dezima Pharma to Amgen for an amount up to US$1.3bn. This was a huge success for the venture capitalists that had set up the company a couple of years before. These examples demonstrate that private equity is a broad concept. In practice, investments in brand new start-ups, growth investments in expanding companies and public-to-private transactions are placed under this asset class. Many other types of investment are also possible within private equity. In this white paper, we examine the different types of investment. We also devote attention to other characteristics of this asset class, such as the potential structures to access the market and how to construct a private equity portfolio. Later on in this white paper we will look in detail at the European market. This is an important region for private equity investments. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 3

4 An introduction to the asset class As mentioned above, private equity encompasses a wide range of potential investments. The common characteristic of these investments is that investors acquire an equity interest in private companies. In doing so, they usually fulfil an active shareholder role 1. The main market segments within private equity are venture capital and buyout capital. Venture capital (VC) concerns investments in start-ups, often with a focus on technology or life sciences. VC managers usually acquire a minority interest, while the majority interest remains in the hands of the entrepreneur. VC investments take place in several financing rounds, which are dependent on the company achieving specific milestones. TABLE 1 PHASES OF THE VENTURE CAPITAL CYCLE VENTURE CAPITAL PHASE Seed Early Stage Late Stage/Growth DESCRIPTION Financing the early development of a product idea Financing further product development and marketing & sales. Product still relatively unproven Financing further expansion. Product technically/commercially proven, focus on further growth VC companies are usually financed (almost) entirely using equity (and therefore often operate without debt on the balance sheet), a major difference from buyout investments. Nevertheless, the financial risks are high. A number of VC companies will not survive due to ultimately being unable to achieve the required scale or profitability. It may also be that the idea simply does not take off. Logically, the failure rate is higher for investments in the early start-up phase of companies and declines as they mature and products have proven themselves more. The flipside is that investments in successful VC companies can generate returns of many times the initial investment. A couple of successes in a VC portfolio can already lead to a sound return on the total portfolio. For this reason, especially when the focus is on early-stage investments, VC managers diversify their funds across approximately twenty to thirty underlying companies. 1 The extent of active ownership is generally lower in venture capital than in buyouts. Yet the level of engagement is often greater than is the case in listed companies. One positive exception to this are long-term value creation strategies in listed equities. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 4

5 Buyout capital usually relates to investments in stable and profitable companies. Buyout managers generally acquire majority interests in these companies, allowing them to exert a great deal of influence over the strategy. Buyout managers often possess specific in-house knowledge and experience to assist them in this. Furthermore, many managers have networks within sectors, which can help to get knowledge and/or personnel on board. Managers generally prefer companies with high and stable cashflows in relatively non-cyclical sectors. A high number of private equity investments occur in particular in the consumer sector (both products and services), business services, industrials and healthcare. Fewer investments are made in capital-intensive and cyclical companies. On average, buyout managers keep companies in their portfolios for about five years before selling them. This explains their preference for less cyclical sectors. When it comes to selling the companies, managers are less dependent on the exact timing and the market cycle and more dependent on their own added value. The average buyout fund invests in about eight to twelve companies. The predictability of buyout investments is higher than that of venture capital. The number of write-offs is also considerably lower and usually confined to a maximum of one or two investments per fund. Moreover, part of the investment may also be preserved in such cases. The role of private equity financing Companies and entrepreneurs can have varying motives for raising private equity financing or selling the entire business to a private equity party. Venture capital provides financing to start-ups that are usually not yet profitable. VC managers supply capital that the company can use to work towards a number of milestones. Moreover, VC managers can help to make the company more professional and the managers networks may bring added value for the entrepreneur. Within buyouts, private equity can provide a solution for vendors in various situations: Owners/entrepreneurs may be seeking a (partial) exit. This may derive from succession difficulties or the desire to convert the company into cash; To achieve a company s growth ambitions. Companies do not always have the required in-house competencies e.g. to implement an international expansion strategy. Specialist private equity parties can provide added value in such cases; To restructure or rationalise operations. In certain cases, private equity parties can provide cash where the alternative is a complete shutdown of activities; To achieve a spin-off or carve-out of specific activities. This often involves complex situations in which experienced private equity parties can help the company to continue independently. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 5

6 Strategies for value creation Value creation in venture capital starts with the economic role of VC investments. This is providing capital to start-ups that have sound business plans but limited access to capital. However, there are huge numbers of start-ups and the results are fairly black and white. Many start-ups fail and only a few are successful. The sourcing of investment opportunities and selection of the right deals therefore make the greatest contribution to the ultimate return on venture capital. When selecting deals, investors need to examine both the ideas or business plans and the entrepreneurs themselves. Especially with tech investments, what counts most for VC managers in the early stages of a company is often the entrepreneur and/or team. The business plan is allotted a greater weight 2 in the later stages. In investments in life sciences, too, the most important aspect is the business plan. Venture capital As VC managers usually hold minority interests in companies, they have less influence over the corporate strategy pursued during the investment period. Yet this does not mean that they cannot provide any added value. VC managers add value via active monitoring and by improving governance. VC manager networks can often be of assistance here, by bringing in both expertise and new key personnel. They may also bring added value to major events such as a fresh round of financing, the sale of the company or its flotation on the stock market. 2 See: How Do Venture Capitalists Make Decisions?, Gompers, Gornall, Kaplan and Strebulaev (August 2016) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 6

7 Buyouts For buyout managers, too, value creation starts with the thorough sourcing and selection of companies. The majority of the value is added in the period that follows, however. How much value depends on the plans the private equity party has for the companies in question. As mentioned earlier, buyout managers exert considerable influence over the company s strategy in their capacity as majority shareholders. The ultimate return for buyout managers can derive from several sources: Increasing the companies profitability. Buyout managers can achieve this in several ways: -- Firstly, the manager can contribute to the company s growth and in doing so its revenue and earnings. This growth may occur organically or non-organically, by means of acquisitions; -- Another way of increasing a company s profitability is to cut costs and create more efficient operations. This may include the sale of non-strategic business units; The sale of companies at a higher multiple than at time of the purchase. Timing plays an important role here. Buyout managers first take the time to acquire a company at a suitable price. They then take an average of five years to find the right buyer for the company. The multiple may also be increased by expanding or transforming companies (leading to buyers being prepared to pay a higher price); Optimising the capital structure using debt financing. One overall aspect to which private equity managers generally devote attention is the company s governance. Improvements to the governance structure enable the company to create value more effectively. Investors in private equity in turn profit from this. In practice, we see that the value creation method is usually related to the size of the investment and the specific private equity managers. For instance, smaller buyout investments are often prompted by a focus on growth and a modest use of debt. In large buyouts, the emphasis is more on cutting costs and financial engineering, i.e. the significant use of debt to optimise the company in tax terms. Although the operational risks usually decrease as the size of the investment increases (larger companies are generally more stable, better established and less dependent on individual products or markets), this use of debt does involve additional financial risks. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 7

8 The best exit strategies The return on investments in private equity remains a return on paper until the investment is sold: the exit. We distinguish three main exit channels for private equity: Strategic sale: the company is sold to a strategic buyer. This is usually a buyer from the same or a related sector that may be able to achieve synergy benefits. Consequently strategic buyers are potentially prepared to pay a higher price than other buyers; Financial sale: the company is sold to another private equity party. Such transactions are also known as secondary private equity deals 3. These often involve companies that have entered the next phase of growth, in which other private equity parties can add more value than the existing owners; Initial Public Offering (IPO): the company is floated on the stock exchange, after which the interest is sold in its entirety or in portions. FIGURE 1 EXIT STRATEGIES PER MARKET SEGMENT 4 Source: Pitchbook, Strategic sale 55% 80% Financial sale 10% 40% IPO 5% 10% Venture Buyout 3 Not to be confused with the secondary buying and selling of private equity funds. 4 The percentages given relate to the number of exits per market segment, whereby all exits have been allocated an equal weight. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 8

9 The exit strategy can vary according to the company and does not need to be decided in advance. Private equity managers may have several exit strategies prepared and decide close to the date of the exit which strategy will yield most value. The individual exit options may also depend on the profile of the private equity party: Large buyout managers do not always have the option of a financial sale. They are often among the biggest financial investors themselves and in the wake of the company s further growth it may have become too big for other financial investors; Mid-market buyout managers usually enjoy the greatest flexibility in their exits as all three options are open to them; Small buyout managers are not always equipped to prepare a stock market flotation. Moreover, the companies are often too small to undergo the relatively expensive IPO process; In the case of venture capital, the most successful investments can grow sharply and then IPOs are a frequently-used exit strategy. Yet strategic sales are also common when it comes to very successful investments. Exits may take longer for less successful and smaller investments, and IPO processes are often too expensive. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 9

10 Investment options Investors in private equity can choose how they wish to gain access to this asset class (see figure 2). FIGURE 2 OPTIONS FOR CREATING PRIVATE EQUITY EXPOSURE Private Equity Fund of Funds Investors Private Equity Fund (direct fund) Companies Source: Kempen The first option for investors is to invest directly in companies. In practice, however, this route is rarely used as it requires a great deal of expertise and resources. When we look at smaller and more local transactions, especially in venture capital, larger private investors do invest regularly using this method though. These are private investors that have no difficulty with holding a concentrated portfolio and a substantial home bias. They include a large number of (former) entrepreneurs who want to enjoy a high level of engagement in their investments. The majority of investors invest via specialist private equity funds (also known as direct funds) that in turn invest in a series of companies. Investors can choose from a wide variety of funds that often specialise in a specific region or market segment. This makes the management of a diversified private equity portfolio relatively labour-intensive. Investors need to make several investments and therefore need to have a relatively large amount of capital at their disposal. Many funds also apply a minimum investment of about 5 million. For this reason, a minimum allocation of about 50 million is required in order to construct a well-diversified private equity portfolio via direct funds. Furthermore, investors need to have sufficient resources at their disposal to select and monitor the investments. Investors may wish to outsource the selection of direct private equity funds to specialist external parties. One way of doing so is to use funds of funds (FoFs). In such cases, investments are made in a fund or mandate of the FoF provider that subsequently invests in several direct private equity funds. Table 2 lists the main advantages and disadvantages of investing via FoFs compared to investments via direct funds. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 10

11 TABLE 2 ADVANTAGES AND DISADVANTAGES OF INVESTING VIA DIRECT FUNDS COMPARED TO INVESTING VIA FUNDS OF FUNDS Advantages Disadvantages DIRECT FUNDS Full control on the portfolio: management, selection and monitoring; Direct contact with managers; High degree of transparency. Relatively high minimum capital requirement to be able to construct a diversified portfolio; Higher internal organisation and expertise requirements; Specific sections of the market less accessible; Higher operational requirements. FUNDS OF FUNDS Relatively simple method of constructing a well-diversified portfolio; Outsourcing of due diligence to a specialist party; Accessible from a relatively small amount of capital. Extra layer of fees; Historical track record less attractive; Longer build-up period for portfolio; Less control over ultimate investments; Risk of over-diversification; Lower transparency in certain cases. Funds of funds typically enjoy broad underlying diversification. It should be noted that there is a risk of overdiversification here. The average fund of funds invests in about 25 underlying private equity funds 5, while many large funds of funds regularly invest in an even higher number of funds. In addition, investors tend to spread their investments across a number of funds of funds and providers in order to spread the vintage year risk 6 and manager risk. When you consider that the percentage allocation to these funds is often small compared to the total investment portfolio, we see a certain level of over-diversification. Such a large number of underlying fund investments means that there is a small chance of alpha. There is also a risk that the performance of large funds of funds tends towards a market beta (with a double layer of fees), while private equity as an asset class in fact offers good alpha opportunities. Partly for this reason, we have seen funds of funds lagging behind in terms of performance compared to direct funds (please also see section 3 Risk and return ). If investors are considering investing in fund of funds, we recommend selecting a fund of funds with a more concentrated portfolio which includes only the investments with the highest conviction. An added advantage is that this usually means portfolio transparency can be better achieved. A special type of funds of funds is known as secondary funds, or secondaries. These are funds of funds that in turn invest in underlying private equity funds that were set up several years ago. These fund interests are purchased from current investors, who for various reasons wish to divest their interests early. Secondary investors generally stipulate a discount on the net asset value (NAV) of the fund in question. This can form an additional source of return for these funds. Secondaries may also be an interesting option during the construction phase of a private equity portfolio (see next section). 5 Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?, Harris, Jenkinson, Kaplan and Stucke (August 2015) 6 The vintage year of a private equity fund usually refers to the year in which the first investment was made within the fund. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 11

12 Co-investment funds Another option is to invest via co-investment funds. Fund-of-funds providers increasingly sell these on a stand alone basis. In a co-investment, an investment is made in a company alongside a direct private equity manager, which usually charges no fees. For the manager it may be advantageous to offer part of the investment as a co-investment if a specific deal is too large to include it in the manager s own fund. Fund-of-funds providers often invest in several co-investments and in turn offer these in funds themselves. These co-investment funds provide a fair amount of diversification, while the fees are similar to or even lower than those for direct funds. Acquiring and managing an allocation Private equity funds have a closed-end investment structure. This means that investors first commit capital to the fund before the fund manager invests it in underlying companies. Fund managers have three to five years in which to invest this capital. This is also known as the investment period. During this period, investors need to deposit net cash into the fund. After a few years the companies are sold and cash distributions are made from the fund to investors. As some years have elapsed, these distributions will be larger than the deposits, i.e. investors receive net cash from the private equity fund. This is also known as the J-curve effect (see figure 3). FIGURE 3 J-CURVE EFFECT OF PRIVATE EQUITY PORTFOLIO Cashflows of investors 75% 0% -75% Vintage year Cash deposits Net cash position (cumulative)] Cash distributions Source: Kempen, September 2017 KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 12

13 The performance of a private equity fund displays a similar pattern. In the early years, the incurred costs are relatively high, while initial investments remain at purchase value in the books for some time. Moreover, management fees for private equity managers are generally calculated over the entire commitment in this period and not just based on the amount of capital invested. As a result, the return may be negative or neutral in the first couple of years. Once the private equity manager has implemented the planned strategic or operational policy and a few years have passed, the underlying companies may profit from an increase in value. The first companies are sold at this point, whereby the sales value on average exceeds the book value. It is in this period that the private equity fund generates the lion s share of its return. As private equity funds often sell the first companies before all the committed capital has been invested, the net amount of capital called will at its height only be about 70 to 80% of the total commitment. In order to acquire the required private equity exposure, investors can opt for an over-commitment strategy. This means that the commitment given is higher than the exposure the investor ultimately wishes to achieve. This requires an accurate assessment of the expected underlying cashflows for the entire portfolio. Whether a portfolio is net cash positive depends on which stage the underlying private equity funds are in. In managing a private equity portfolio we initially examine the expected cashflows of the funds over a period of several years. Taking this together with the intended strategic targets (e.g. regional or market segment allocation) as a basis, a commitment plan can then be drawn up for moving towards the required exposure. An over-commitment strategy can bring exposure to the required level and prevent the allocation remaining structurally below the strategic weight. The management of the private equity portfolio also demands continuous maintenance. Private equity managers distribute capital after the sale of a company to investors, who then need to reinvest this in order to keep exposure at the required level. For this reason, investors need to monitor interesting fund managers that are at or near the point of raising a new fund on a continuous basis. Specialist secondary funds can help investors starting out in private equity to reduce the J-curve. As secondary funds invest in private equity funds that have already been set up, distributions are paid almost immediately following exits by underlying companies. Moreover, from a return perspective these funds can help mitigate the J-curve. This is because the discounts negotiated in the purchase process are entered into the books directly as return and some of the underlying costs have also already been paid. Figure 4 contains the average pricing on the secondary market in private equity. Note that there is relatively wide dispersion in pricing. The funds of high-quality managers trade at lower discounts or even at a premium. At low-quality managers, investors need to take account of considerable discounts. Furthermore, buyout funds generally trade closer to the Net Asset Value than e.g. venture capital funds or funds of funds. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 13

14 FIGURE 4 AVERAGE PRICING ON SECONDARY MARKET 110% 100% 90% 80% 70% 60% 50% 40% Average pricing (% of NAV) Source: Greenhill Cogent 2016 Careful construction of a private equity portfolio also involves wide diversification across vintage years. It is a good idea for investors to establish this in advance in an investment plan with a long-term horizon. After all, investors have a tendency to invest large amounts in private equity during bull market years. They are more cautious about new investments during crisis years. In retrospect, however, it turns out that investment was high in vintage years with poorer performances and low in high-performance years. This is a very common bias and not confined to smaller and less professional investors, but also applies to large specialist parties 7. 7 See also: Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?, Harris, Jenkinson, Kaplan and Stucke (August 2015) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 14

15 Risk and return Historically attractive returns Different measures are required to assess the returns earned by private equity managers than the simple timeweighted returns usually used for listed asset classes. Private equity investments are conducted via closedend fund structures. This gives the private equity managers control over the timing and size of the cashflows between investors and the fund and vice versa. As a result, the actual invested capital can vary hugely from year to year. A simple time-weighted return would therefore provide an inaccurate picture of the performance. In practice, a money-weighted internal rate of return (IRR) is often used to assess the performance of private equity managers. When making the comparison to the public markets, the public market equivalent (PME, see next section) is also used in order to allow a better comparison of returns. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 15

16 Figure 5 shows the average IRR of private equity managers over the past twenty vintage years. The IRR shown is the weighted return that was earned during the holding period of the investments by funds that were set up in the specific vintage year. We have placed data from two commonly-used benchmark providers alongside each other here (Preqin and Cambridge Associates). The Preqin index includes all underlying private equity strategies, while the Cambridge Associates benchmark focuses on buyout and growth funds and excludes venture capital funds. FIGURE 5 AVERAGE IRR OF PRIVATE EQUITY FUNDS 40% 35% 30% 25% 20% 15% 10% 5% 0% Vintage year Preqin (weighted average IRR) Cambridge Associates Global Buyout & Growth (pooled IRR) Source: Preqin, Cambridge Associates, as of 30 June 2016 (net, after the deduction of all fixed and variable fees) over the past twenty vintage years 8 As figure 5 demonstrates, the average returns of the two providers are fairly similar in some years while there are considerable differences in others. This is not entirely surprising given the differences in composition of the two benchmarks. In particular the fact that venture capital funds are included in the Preqin benchmark but not in that of Cambridge Associates makes a clear difference. This can be seen in especially positive ( , ) and negative vintage years ( ) for venture capital. In absolute terms, the performance of private equity has historically been attractive. Sound positive net returns were earned even in difficult vintage years such as 2006 and The significant differences between vintage years underline the importance of a proper diversification. 8 Based on Preqin data consulted on 12 April We show the data as of 30 June 2016 in order to encompass the most complete peer group possible in the comparison of the data from the two providers. The vintage years are not included due to the short duration of these funds. As a result, the performance data for these vintage years is not yet significant. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 16

17 Looking at private equity performance in the most important regions (North America and Europe), we see no significant differences in performance in the long term. Yet the relative performance of these regions is cyclical. Although there are substantial differences in performance in some vintage years, market timing is not easy in relation to geographical allocation and different market segments. One of the reasons for this is that it is tricky to act based on current market information (such as differences in valuation). After all, private equity funds invest the committed capital over a period of three to five years. As a result, the actual date of investment is not the same as the date of the decision to invest. Table 3 contains the long-term performance in different regions of several long-term Cambridge Associates indices. TABLE 3 LONG-TERM PERFORMANCE (pooled IRR, in US dollars, after the deduction of fees) INDEX 10-year IRR 15-year IRR 25-year IRR Cambridge Associates US Buyout Index Cambridge Associates Ex-US Buyout Index Cambridge Associates Europe Developed PE & Venture Capital Index 11.2% 12.7% 13.1% 9.2% 13.5% 13.4% 9.3% 14.4% 14.5% Source: Cambridge Associates indices (as of 30 September 2016) With respect to market segments within private equity, venture capital is clearly more cyclical and more volatile than buyout capital. Venture capital performed well for a long period in the 1990s. Its performance was disappointing in the subsequent decade, although it has picked up again sharply since. Moreover, at underlying company level a venture capital investment is much more black and white than a buyout investment. One or a few home runs can determine the fund s return. Furthermore such successes are needed to compensate for write-offs in the portfolio. Looking at the size of the funds, on average in the long term we see no obvious differences in performance between smaller and larger funds. In the venture capital market, the very smallest funds (the bottom quartile in terms of size) do perform less well than the larger funds 9. This is no surprise given the high pioneer character of these funds and the fact that fees are often relatively high compared to the invested capital. 9 See: Private Equity Performance, What Do we Know?, The Journal of Finance (Volume 69, Issue 5), Harris, Jenkinson and Kaplan (October 2014) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 17

18 Outperformance compared to public markets Over the past few years, the comparison of private equity returns to listed equities returns has mainly been conducted based on public market equivalent (PME) multiples. Here, the net cashflows of private equity funds are discounted against the return of the public market during the same period. This yields a purer comparison than the money-weighted IRR of private equity funds in comparison to the time-weighted returns of public markets. Recent studies report an outperformance by private equity compared to public markets. The study by Harris, Jenkinson and Kaplan (2014, Journal of Finance) of the US market and a subsequent study that includes the European market 10 are the most extensive of those studies conducted recently. They use cashflow data from the Burgiss database. These data derive from institutional investors who use Burgiss as a platform and therefore not directly from the private equity managers themselves. Harris, Jenkinson and Kaplan report a net outperformance from buyouts of about 3% per year versus public markets. Also compared to listed small-cap equities an outperformance is found. The outperformance can be observed in both the US and Europe. No significant differences in performance were found between US and European buyout funds. Venture capital funds also display an outperformance. This applies to the US venture capital funds but not to their European counterparts. Furthermore, the relative performance of venture capital versus the public markets varies greatly over time. The relative performance of venture capital funds in relation to public funds observed in the literature therefore depends strongly on the selected time period. 10 See: How Do Private Equity Investments Perform Compared to Public Equity?, Journal of Investment Management (Volume 14, Issue 3), Harris, Jenkinson and Kaplan (June 2016) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 18

19 Direct funds versus funds of funds Private equity investors have the option of investing in direct funds or in funds of funds. These funds of funds provide additional diversification, but usually also claim to have above-average in-house selection expertise or access to good managers. These claims should justify the higher fees for these funds of funds. In practice, however, we can see that in the past funds of funds have lagged behind direct funds on a net basis. Figure 6 depicts this in the form of a graph. FIGURE 6 PREQIN QUARTERLY PRIVATE EQUITY INDEX VS. PREQIN QUARTERLY FUNDS OF FUNDS INDEX Preqin Private Equity Index Preqin Funds of Funds Index Source: Preqin, 30 June 2016 Based on the returns in the Preqin database, funds of funds lag behind the general private equity index by over 2% per year 11. The literature 12 on the subject confirms this picture for buyout investments, while the performance of venture capital funds of funds is similar to that of direct funds. The latter can potentially be explained by the higher persistence of returns within venture capital (repeat robust performances from specific managers in successive funds). The fact that experienced funds of funds may also have above-average access to the better managers in this segment may also play a part. 11 This is not the ideal comparison as there is some overlap between the two indices. The Preqin Private Equity index contains about 11% funds of funds. However, these are the most appropriate indices for depicting the difference in performance in a graph. 12 See: Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?, Harris, Jenkinson, Kaplan and Stucke (August 2015) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 19

20 Nevertheless, the underperformance of funds of funds in buyouts is striking. The additional layer of fees involved in funds of funds logically makes it trickier to earn a high performance. This effect will diminish slightly because fund of funds fees have declined over the past few years. However, it is worth noting that an investment in a traditional (closed-end) fund of funds extends the J-curve considerably. This is because in addition to the investment period of the underlying private equity funds account needs to be taken of the investment period of the fund of funds. Commitments are made to the underlying funds during this period. During this investment period, management fees are paid based on the total commitment, leading to the return initially being substantially more negative. It is difficult to make up for this lag in performance in the later years of the fund of funds duration. Dispersion of returns During the period that private equity managers hold an investment the value creation is skill-based. Private equity managers actively add value to the companies in which they invest. It should be remembered that the companies do not have a broadly diversified shareholder base and that there are no investible benchmarks. Moreover, private equity funds are considerably more concentrated than normal equity funds, often containing about eight to twelve investments for a buyout fund. The investment returns also vary greatly, especially at smaller companies. For all these reasons, the returns on private equity funds which otherwise are similar in terms of vintage year and strategy vary sharply. The dispersion of returns is high and also considerably higher than is the case for listed markets. Figure 7 gives the dispersion in performance of European buyout managers, looking at the net IRR. The median, the inter-quartile range and the minimum and maximum IRR of the funds are given for each vintage year. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 20

21 FIGURE 7 PERFORMANCE DISPERSION OF EUROPEAN BUYOUT FUNDS, LOOKING AT NET IRR 13 80% 60% 40% 20% 0% -20% -40% Vintage year Source: Preqin (entry date 13 April 2017) As can be seen in the figure, the performance of individual funds varies widely, in spite of the fact that this only involves European buyout funds. In some years, the inter-quartile range, which contains the 50% of funds closest to the median, stood at about 25% and more recently at about 10%. This major dispersion in fund returns means that manager selection has a significant impact on the ultimate return in this asset class. Figure 7 also shows that it is essential to avoid the 4th quartile funds (the 25% of poorest performers). The dispersion in returns for investments funds of funds in comparison is much smaller due to the wide diversification these funds usually offer. Persistence in manager returns In the 1990s, the returns on private equity funds typically displayed a high degree of persistence. The chance of a fund managed by a manager with successful previous funds again performing well was considerably higher than for a fund managed by a less successful manager. More recently, it has been demonstrated that this persistence has largely dissipated for buyout funds 14. One aspect that could play a role here is that many successful buyout managers grow rapidly and as a result of the increase in the size of the fund start to operate in a different market. This can hamper their ability to replicate past successes. Continuing to invest in a wellperforming manager is therefore less of a no brainer than one might initially think. 13 Based on the most up-to-date data per fund, as consulted in Preqin as of 13 April See: Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds, Harris, Jenkinson, Kaplan and Stucke (February 2014) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 21

22 Another aspect is that private equity parties tend to boost their returns somewhat prior to and during fundraising. This is done via exits and by upgrading valuations. The reported returns have little predictive value for future performance, especially when the IRR is examined 15. Investors consequently need to conduct thorough due diligence before investing in a new manager, or in a new fund being set up by an existing manager. It is essential to take a critical look at the extent to which past performance can be repeated in the future. Significant persistence can still be found in returns of venture capital, however. This does not come as a surprise to us: successful venture capitalists act as a magnet to young, talented entrepreneurs who present their business plans to them first. This means that successful and renowned venture capital managers have a wider choice of investments than less successful managers. This presents challenges for investors who wish to invest in this segment, particularly in the US where investors experience difficulty in accessing high-quality managers. As venture capital is not scalable and existing investors usually continue to re-invest via these managers, there is little room for new shareholders in these funds. In this market, it may be worth considering a specialist fund of funds with proven access to these managers. Although certain US venture capital managers could be more interesting than those in other regions, the question is whether this is still the case though when the additional layer of fees charged by funds of funds is taken into account. Main risks and points for attention Market risk Returns on private equity investments depend partly on the financial markets and the economic cycle. Relatively high multiples are currently being paid for companies, especially at the upper end of the market. As a result, expected returns are lower than in periods of lower valuations. Public market valuations have a direct and indirect impact on private equity valuations. After all, these affect potential exits values (e.g. via stock market flotations or sales to listed companies) and the valuations that private equity managers use for their companies. Listed companies with comparable corporate profiles are often a point of reference for valuations. Another market risk applies to venture capital managers in addition to valuation. The business model of venture capital investments needs to prove itself on the market. At company level, this translates into a particularly high market risk for these investments. It is not just the quality of the business model that is a decisive element here, but also how the competitive landscape evolves (e.g. superior alternative technologies or medicines). 15 See: How Fair are the Valuations of Private Equity Funds, Jenkinson, Sousa and Stucke (February 2013) KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 22

23 Leverage The use of leverage varies greatly in the private equity sector. Very little leverage is used in venture capital, especially in early-stage investments. In buyouts, leverage is often an explicit component of the strategy. A substantially higher amount of leverage is used in larger buyouts compared to smaller buyouts. The use of leverage increases the risk profile of a private equity investment. There is a higher risk of the investment ultimately having to be written off. It is important to note here that the leverage is acquired at company level and not at fund level. This means that any consequences are for the account of the individual company and not the entire fund. The bankruptcy of a single company will not necessarily have a major impact on the return of the fund as a whole. This can be the case in other asset classes, such as real estate (e.g. when the entire portfolio serves as collateral for the funding). Concentration As mentioned earlier, private equity funds are more concentrated than listed equity funds due to the number of companies held in the portfolio. Investors generally mitigate this risk by allocating smaller percentages to individual private equity funds than to individual listed equity funds, even if the total private equity allocation is larger. Moreover, investors need to ensure sufficient diversification across the number of private equity funds held in the portfolio. Illiquidity Investments in private equity are first and foremost illiquid investments. Investors need to realise that they cannot immediately withdraw the invested capital. Private equity managers retain the investments in the underlying companies for an average of five years before the companies are sold or floated on the stock market. Yet this period can vary and depends partly on the economic cycle. The uncertainty about liquidity flows can cause liquidity risk if too large a portion of an investor s assets is invested in private equity (or other illiquid asset classes). During crisis years, investors need to take account of low distributions, while capital calls may still be made for new investments. We therefore recommend applying a bandwidth containing a certain buffer before liquidity can become a real problem. In practice we rarely see investors though with such high allocations to private equity that the illiquidity of the investments forms an actual risk. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 23

24 Private equity in a broader investment portfolio Incomparable potential returns Private equity is a return-driven asset class that is viewed by many investors as an alternative to listed equities. Although private equity also provides some diversification (chiefly because it invests in a different segment of companies that is not always accessible via the stock market), this is not usually a decisive factor. After all, the asset class has a positive correlation to listed equities due to the dependencies in the exit strategy and for the valuations used. There are other alternative asset classes that provide greater diversification compared to a traditional portfolio containing equities and bonds. From a return perspective, however, few asset classes enjoy potential returns comparable to those of private equity. As a result, in practice considerably higher private equity allocations are found among investors with higher required returns. Size of private equity allocation The size of the allocation to private equity in a general investment portfolio cannot be viewed entirely separately from the allocations to other illiquid asset classes, such as private real estate and infrastructure. After all, many investors apply an upper limit to the total amount of illiquid investments they wish to include in their portfolios. This upper limit depends on the type of investor, the investor s expected cashflow profile and the certainties and uncertainties this encompasses. In practice, pension funds that invest in private equity generally hold a strategic allocation of 5 to 10%. This level of allocation does not usually pose liquidity problems at pension funds. After all, they tend to have longterm liabilities and therefore low liquidity requirements. We do recommend holding a minimum allocation of about 5% with a view to the materiality in the general investment portfolio. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 24

25 At insurers, private equity allocations depend greatly on the type of insurance company and the applicable laws and legislation. Preqin 16 estimates the average allocation at insurers to be about 3%. This relatively low percentage is due to the often higher liquidity requirements at insurers and the relatively high capital lock-up that applies to insurers based on Solvency II. In contrast to pension funds and insurers, family offices do not need to hold investments that are driven by legislation or prompted by a pure cashflow matching policy. As a result, on average family offices hold much less bonds and their allocation to alternatives is considerably higher than that of pension funds. UBS and Campden Wealth 17 estimate the average private equity allocation of family offices to be about 22%. It is possible to manage such allocations properly from a liquidity perspective as long as liquidity requirements are low and investment horizons are sufficiently long. We also see similar allocations to private equity at the major US endowment funds (e.g. university funds that manage donations made to these institutions). 16 See: Preqin: Insurance Companies Investing in Private Equity 17 See: Global Family Office Report 2016, UBS & Campden Wealth KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 25

26 Figure 8 depicts the average family office asset allocation. This is based on research by UBS and Campden Wealth 18 among 242 family offices worldwide, 75% of which are single family offices. FIGURE 8 ASSET ALLOCATION AT FAMILY OFFICES 19 Equities Bonds Private real estate Private equity Hedge funds Other alternatives Cash 9.0% 8.1% 9.3% 8,9% 7.9% 8.4% 14.8% 13.3% 11.3% 11.5% 19.8% 22.1% 27.8% 27.4% Source: UBS, Campden Wealth, 2016 It is often difficult for smaller private investors to invest in private equity. The listed investment opportunities in private equity often have substantially different return characteristics, causing potentially substantial deviations in the underlying return drivers. Yet private equity can form an interesting asset class for this client group. The planned allocation will depend strongly on the investment horizon, liquidity requirements and the degree of professionalism among these investors. The question is whether traditional closed-end fund structures are the most appropriate for this client group due to the often restricted diversification and corresponding operational complexity. In addition to defining a percentage allocation to private equity, investors also need to look at the absolute size of the allocation. This can have an impact on the individual investment options (such as the choice between direct funds and funds of funds). 18 See: Global Family Office Report 2016, UBS & Campden Wealth 19 REITs (Real Estate Investment Trusts) are included here under Equities, and Agriculture and Commodities under Other alternatives. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 26

27 The European private equity market Growing market dynamics Alongside the US, Europe is the most important market for private equity investments. The number of active companies in the EU is estimated at over 22 million (source: Eurostat). The universe of companies that could be interesting prospects for private equity is therefore especially large 20. Investments in private equity buyouts are often compared to investments in listed small-cap companies. However, a closer examination of the private equity market reveals that while there is some overlap in the size of the companies, private equity also offers access to a segment of considerably smaller companies. Figure 9 shows the size and number of companies in which investment was made in the European buyout market over the period FIGURE 9 SIZE PER INDIVIDUAL PRIVATE EQUITY INVESTMENT* bn < 15m m m > 300m Total transaction value Total transaction value (left axis, bn) Number of companies (right axis) Source: Invest Europe / PEREP Analytics * in relation to the number of investments and the total transaction value in the European buyout market over the period As figure 9 demonstrates, only about 20% of European buyout investments in this period comprised equity tickets of over 300 million. Approximately 80% consisted of smaller investments. As a comparison: the average market capitalisation of companies listed in the MSCI Europe Small Cap Index is in excess of 1 billion, while the minimum market capitalisation for inclusion in this index is nearly 500 million. This emphasises the 20 As a reference: the number of companies included in the MSCI Europe index is about 450 and the number of companies included in the MSCI Europe Small Cap Index is about 950. Source: Eurostat. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 27

28 fact that private equity and listed small caps only enjoy restricted overlap. Allocations to both asset classes are in fact complementary. When we include venture capital in the comparison, this complementarity is even higher. This is because this type of investment is usually completely inaccessible via the stock market. Just as for many other asset classes, interest from investors and capital inflow into private equity have increased as a result of the expansionary monetary policies pursued by central banks. Figure 10 depicts the growth of the European private equity market over the past few years. FIGURE 10 CAPITAL RAISED AND DRY POWDER IN THE EUROPEAN PRIVATE EQUITY MARKET bn Capital raised Dry powder Source: Preqin, 2017 As a result of the increase in capital raised by private equity managers, the amount of available capital for investments (known as dry powder) is at a record high. Moreover, this capital will actually have to be put to work in the next few years. This large amount of dry powder is creating greater competition for certain deals and relatively high valuations. This is being mitigated somewhat by the fact that the private equity market has grown considerably over the past decade. Furthermore, annual investment volumes have increased, leading to dry powder being invested more quickly. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 28

29 Difference in valuations The higher valuations of private equity companies are not unique. The search for yield has led to high valuations and low expected absolute returns in almost all asset classes. Compared to other asset classes, private equity should be able to perform well thanks to the high degree of skill-based value creation it entails. Yet investors do need to take a close look at valuations. They also need to be selective with respect to the market segments in which they invest and the amount of leverage applied. Figure 11 depicts the valuations of European buyouts from a historical perspective and divided according to the size of the investment 21. FIGURE 11 AVERAGE PURCHASE MULTIPLES (EV/EBITDA) FOR EUROPEAN BUYOUTS, DIVIDED ACCORDING TO SIZE OF TRANSACTION EV/EBITDA purchase multiples Large LBOs (> 500m) Mid-market LBOs (< 250m) Source: S&P LCD, Probitas Partners, Kempen, 2016 Figure 11 shows that the differences in valuation between larger and smaller buyout deals have grown substantially over the past few years. We believe that the valuation risk in small and medium-sized buyout investments is currently lower than for large buyout deals. A small difference in valuation between larger and smaller companies is normal. Larger companies are usually more mature and stable and have better access to capital. Yet the current difference is large and from a valuation perspective we prefer funds that focus on small and medium-sized companies. Private equity managers that focus on small and medium-sized companies also have the opportunity to increase the size of the companies in the portfolio significantly. As a result, in many cases when they are sold the managers receive a higher multiple than on purchase. The latter can serve as a buffer in the event of future market corrections. Moreover, the valuations of large buyout deals are more strongly correlated to listed equity markets and the availability of debt. 21 In 2009 and 2015, the median for the previous and following years have been used for mid-market buyouts due to the lack of statistically significant data points for these years. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 29

30 It should be noted that the timing of investments in private equity is a tricky if not impossible task. The reason is the significant amount of time that elapses between the date of the investment decision and the actual investment. As far as we are concerned, the primary starting point for portfolio construction is a properly diversified portfolio, in which up-to-date market information can be used to create further nuances in the portfolio. Buyouts The buyout sector encompasses the greater portion of the European private equity market. European buyout funds can be divided into pan-european funds and funds that focus on a specific region or country. The majority of buyout managers is sector-agnostic. Managers do sometimes have a preference for or special expertise in certain sectors. Sector-specific funds are less common. Table 4 lists the ten largest buyout funds in terms of capital raised by European private equity managers in the past three years and the ten largest buyout funds in the Netherlands in the past five years. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 30

31 TABLE 4 TOP-10 BUYOUT FUNDS ACCORDING TO SIZE IN EUROPE* EUROPE CVC VII (2017) Apax IX (2016) Permira VI (2016) Cinven VI (2016) EQT VII (2015) Permira V (2014) Ardian LBO VI (2016) Bridgepoint Europe V (2015) Carlyle Europe IV (2015) Bain Capital Europe IV (2014) 16bn 8bn 7.5bn 7bn 6.8bn 5.3bn 4bn 4bn 3.9bn 3.8bn *Committed capital since Source: Preqin, Kempen 2017 In practice, the market for large buyout deals is dominated by global or pan-european funds with considerable fund volumes. These parties are in a position to assess the relative attractiveness of investment opportunities in different regions and countries. Furthermore, the underlying companies often have a significant pan- European or global presence. A private equity party with expertise and presence in several countries can consequently add value. The universe of potentially interesting investment opportunities is much larger for small and medium-sized buyouts. Here, a regionally-oriented party with strong local expertise and presence can in fact add a great deal of value. Local players often have the best local networks. This can be a huge advantage when sourcing investment opportunities. Many buyout managers prefer stable companies with a sound competitive position and sufficient opportunities for growth. They tend to avoid capital-intensive and cyclical sectors. Yet there are also managers who focus precisely on poorly-managed companies or companies in operational or financial difficulties. Their intention here is active value creation. We believe that such managers can be an interesting addition in terms of the risk/ return profile and complement more mainstream buyout funds. Venture capital The European venture capital market has long been underdeveloped compared to its US counterpart. The amount of available capital for European start-ups is negligible compared to that for US companies. In practice, we can identify a relatively small number of late-stage or growth funds in Europe. This can pose problems for continued investment in growing start-ups. In such cases, European VC companies for late-stage financing are occasionally dependent on US capital. The small amount of capital available for European venture capital projects is partly the result of the historically mixed performance of managers in this segment. A lessdeveloped venture capital culture or a smaller arsenal of serial entrepreneurs (entrepreneurs that set up KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 31

32 successive companies) 22 could perhaps explain this varying and sometimes poor historical performance. Yet there certainly are opportunities in the venture capital segment in Europe 23 and we believe that this market is becoming increasingly attractive. Many European cities (such as Berlin, Amsterdam and London) are home to an ever more positive venture capital climate. Moreover, among younger generations working for start-ups has gained status compared to a career in business. Rapid technological developments are shaking up the status quo and causing new, innovative companies to enter established industries. Examples include the rapid rise of technology in the medical sector (medtech), agricultural sector (agritech) and financial sector (fintech). There are local clusters of expertise in specific market segments in which venture capital managers have delivered proven added value. For instance, several successful managers are active in the life sciences sector in the Benelux. Moreover, they operate in a market that is less competitive than many other parts of the private equity market. Figure 12 depicts the growth of the European venture capital market measured according to different aspects. FIGURE 12 CAPITAL RAISED, EXIT VALUES AND NUMBER OF INVESTMENTS IN EUROPEAN VENTURE CAPITAL MARKET Source: Pitchbook, 2017 bn Capital raised VC managers Number of VC investments (right axis) Exit values VC managers (left axis, bn) From the figure it is possible to see that investment in the European venture capital market has grown substantially over the past ten years. We can observe an increase in the amount of capital raised by venture capital managers. However, closer analysis shows that the number of VC funds that have successfully raised capital has in fact shrunk considerably in recent years. Investors are increasingly opting for larger and more experienced VC managers. The market share of funds below 100 million dropped below 50% in A few years ago, this share still stood at about 80%. In addition, the number of funds that underwent their final closing in 2015 and 2016 had more or less halved compared to five years ago. It will be interesting to see 22 See: European Venture Capital: Myths and Facts, Axelson and Martinovic (July 2015) 23 In addition to the already highly-developed Israeli venture capital market, which is sometimes included in European mandates. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 32

33 whether this is a temporary effect or more structural and what the impact will be on initial financing rounds for new start-ups. Figure 12 also shows that European VC managers have conducted significant exits over the past few years. This is a major development as successful exits are ultimately the best validation for investment in this market. Furthermore, an increase can be observed in the number of companies financed by VC that have already achieved considerable valuations but have not yet been sold. Examples include Spotify, Klarna, Delivery Hero, HelloFresh, Skyscanner and Adyen. Leverage In buyout investments, private equity managers make use of debt, or leverage. A higher amount of leverage enables them to earn higher returns, but the financial risk run by investors is also higher. This is certainly the case in markets with relatively high valuations. Figure 13 shows the use of leverage in European buyouts over the years. FIGURE 13 APPLICATION OF LEVERAGE IN EUROPEAN BUYOUT MARKET (MEASURED ACCORDING TO % OF EQUITY AND DEBT/EBITDA MULTIPLE) Source: UBS, S&P LCD, % 7 50% 6 40% 30% % 2 10% 1 0% % Equity (left axis) Debt/EBITDA multiple (right axis) The figure demonstrates that the use of leverage has increased slightly recently, but that it is not yet back at the level of It is true that market interest rates on debt are low, but lenders are more cautious than they were prior to the 2008/2009 financial crisis. We view this as a positive development that restricts the downside risk of investments. Incidentally, the use of leverage depends greatly on the size of deals. A considerably larger amount of leverage is used in larger deals than is the case in smaller deals. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 33

34 Manager universe and fund characteristics Manager universe Manager databases such as Preqin contain a large number of private equity managers. Over two thousand managers are active in the European private equity market alone. What initially appears to be a huge universe can be reduced to a more manageable overview of the most interesting managers per segment, region or country. This leaves us with a universe containing about three hundred managers. Maintenance and monitoring of a manager universe is a continuous task. Given the trend of larger and more established parties attracting an increasingly large portion of capital it has become more difficult for new private equity parties to raise capital. New and less established private equity parties have a strong incentive to perform in order to build up a sound track record. The business and continuity risks for these parties can be considerable though as their teams and processes have not yet always proved themselves. There is a considerably lower risk involved in choosing a more established party. KEMPEN WHITE PAPER \ PRIVATE EQUITY \ 34