PEQ Research isted Private Capital Accessing growth, diversified investment strategies and returns June 2018 SPONSORED BY I P O R TA N T I N F O R AT I O N This report has been prepared by PEQ imited to provide background information on the listed private capital market. It should not be construed as investment research. While all reasonable care has been taken to ensure that the content herein is accurate, no reliance should be placed on the accuracy, fairness or completeness of the information contained in this document. Visit the PEQ website www.lpeq.com
Who we are PEQ represents listed private capital, including listed private equity funds, debt funds and other multi-asset managers. PEQ provides its embers with a platform that reflects the listed private capital markets, aligns it with the broader capital markets and gives a strong platform to engage with investors and other market participants. Our purpose PEQ was established to deepen public market investor understanding of listed private equity, the investment case for the asset class and as a platform to access investors. In line with market developments, evolving investment strategies and the attractiveness of the private capital markets, PEQ s purpose is to be the leading international platform for listed private capital funds providing a platform and network to optimise the understanding of diverse investment strategies, performance and attractiveness to public market investors. embership PEQ aims to be the leading international platform for listed private capital managers with a shared vision of shaping the industry and its place in the public markets. By becoming a member, not only will you enhance your company s standing in the listed private capital industry, you will gain valuable insight into the sector, connecting and networking with a wealth of private capital market investors and expertise. PEQ s membership is comprised of leading international listed private capital companies, investing in private equity, debt or across multi-asset classes. PEQ s Adviser embers consist of leading international legal, accounting and advisory firms specialised in public market investment funds, structures and investor relations. EUROPEAN OPPORTUNITIES IITED FOR FURTER INFORATION ON PEQ Please contact: Douwe Cosijn: +44 (0)7899 663441 douwe.cosijn@lpeq.com Or visit the PEQ website www.lpeq.com
isted Private Capital Accessing growth, diversified investment strategies and returns Introduction This paper seeks to provide a broad overview of Private Capital ( PC ) from the perspective of a public markets investor looking to understand what it is, why it has grown so rapidly as an investment subset over recent years and what investment objectives Private Capital might help an investor to achieve. The paper then considers how isted Private Capital ( PC ) enables public markets investors to access Private Capital and discusses some of the key considerations for a public markets investor contemplating an investment in isted Private Capital. In discussing the drivers behind the growth in Private Capital as an asset category, we use the definition of Private Capital used by Preqin private closed-end funds, including private equity, private debt, private real estate, infrastructure and natural resources. But in considering the different subsets, we focus on private equity, private debt and infrastructure, since real estate and natural resources, at least as standalone investment strategies, are considered out of scope. The paper proposes that adding Private Capital to a traditional public markets portfolio through isted Private Capital can broaden the opportunity set (by providing access to assets and investment strategies not found in public markets), boost return potential, enhance yield, improve portfolio diversification and provide some protection against inflation. isted Private Capital exists to enable public markets investors to invest in Private Capital through the stock market, thereby avoiding the regulatory and other barriers to access, as well as the complexity and illiquidity involved in undertaking Private Capital investment by the traditional limited partnership route. The rest of this paper is structured as follows: Drivers of the Private Capital markets Overview of the main asset classes within Private Capital Investment objectives addressed by Private Capital isted Private Capital key investor considerations Conclusion 1
Drivers of the Private Capital markets Private Capital assets under management increased from $0.7 trillion to $4.9 trillion between December 2000 and June 2017 (Source: Preqin), representing a CAGR of 12.5% p.a. This growth reflects a number of drivers: Increased demand from investors. Investors, such as pension funds, sovereign wealth funds, endowments and high net worth individuals, have increasingly turned to PC as they seek ways to diversify portfolios, reduce risk and enhance returns. Pension funds, faced with large and growing deficits, see PC as a source of alpha (above-market returns) as well as offering a broad range of yielding investments to enable them to meet their liability obligations. Sovereign wealth funds, to take another example, have turned to PC to help address shortfalls and volatilities caused by energy sector price swings. Investors allocating to PC markets like the PC investment models and believe in the ability of PC to outperform public markets on a sustainable basis. Outlook for returns in public markets. arket commentators are holding out the prospect of a sustained low-return environment in public markets over the next 20 years, both for equities and fixed income. This follows the low-yield environment that has persisted since the economic crisis of 2007-08, as governments have implemented expansionary monetary policies. Public markets less attractive to smaller private businesses. Recent years have seen a trend of falling numbers of listed companies and growth in the number of private businesses. &A activity, corporate failures and take-private transactions have reduced the number of listed businesses. Smaller private companies are increasingly choosing to stay private in order to avoid the regulatory and other burdens of being a listed company and because of the higher availability of private funding than in the past. In addition, public credit markets have over recent years become less receptive to smaller and more lowly-rated issues. Reduction in bank lending to corporates combined with increased demand from corporates. istorically, banks have been the primary source of debt finance for European companies, whereas, in the US, this funding has been predominantly institutional. Post the economic crisis of 2007-08, bank lending to corporates has reduced significantly, particularly in Europe, in response to regulatory and balance sheet pressures on banks to repair balance sheets. Banks have both reduced their activity in the new corporate loans market and have also made substantial dispositions of loan assets to market participants. At the same time, post the crisis, SEs have sought fresh loan funding to refinance existing loans and fund business growth strategies. Increased role for private funding in public infrastructure projects. Over the last 20 years, governments have increasingly resorted to private sector funding of infrastructure spending in the face of constrained budgets. According to a study by ckinsey (2016), the world needs to invest $49 trillion globally by 2030 in building and maintaining core infrastructure (transportation, power, water, and telecommunications). The large deficit is the result of decades of insufficient spending, primarily by governments, which have not invested to meet the needs of growing and increasingly urbanized populations. Growth of multi-asset managers within Private Capital. The period since 2000 has seen a number of private equity fund managers broaden their product offering to include a range of PC asset strategies. This was partly in response to demands from P investors, keen to invest with fund managers they trusted and to reduce the costs and risks involved in selecting and managing multiple fund manager relationships. Some larger P investors also favoured using multi-asset fund managers because this enabled them to deploy large amounts of capital with one party, using their large investment to negotiate reduced fee rates and other special terms such as co-investment rights. The fund managers responded enthusiastically to these demands, since it allowed them to improve their own diversification and increase their ability to manage and deploy larger amounts of capital. 2
ain asset classes within Private Capital As noted in the Introduction, Preqin defines Private Capital to include private equity, private debt, infrastructure, private real estate and natural resources, and usefully breaks each of these down further (see Exhibit 1 below) to give a sense of the investment opportunity set available within Private Capital. This paper focuses on private equity, private debt and infrastructure, since private real estate and natural resources are considered out of scope. Exhibit 1: Analysis of Closed-End Private Capital Closed-End Private Capital Private Equity Private Debt Real Estate Infrastructure Natural Resources Buyout Venture Capital Growth Direct ending Distressed Debt Private Equity Real Estate Infrastructure Energy Agriculture Turnaround ezzanine etals & ining Other Private Equity Special Situations Private Equity Real Estate Fund of Funds Infrastructure Fund of Funds Timberland Private Equity Secondaries Private Equity Fund of Funds Venture Debt Private Debt Fund of Funds Private Equity Real Estate Secondaries Infrastructure Secondaries Water Natural Resources Fund of Funds Source: Preqin An overview of the Private Equity, Private Debt and Private Infrastructure asset classes, including a summary of the broad investment strategies within each, is provided in the Appendix. 3
Investment objectives addressed by Private Capital Within the Private Equity, Private Debt and Private Infrastructure asset classes, there is a range of investment strategies (see Appendix), each with its own risk-return characteristics and cash-flow profiles. Exhibit 2 below contains an assessment, for illustrative purposes only, of how these investment strategies might rate against key investment objectives. For example, Infrastructure Debt offers stable and predictable cash-flows to fund investors, but low scope for investment returns beyond the running yield, whereas Private Equity Buyout offers high scope for capital gains but with lumpy and unpredictable cash-flows. Infrastructure s Core and Value-Add strategies offer diversification potential and some correlation of returns with inflation, since revenues are generally based on long-term contractual arrangements (sometimes with inflation-linkage) and relate to essential assets and services. Exhibit 2: Assessment of investment strategies against various investment objectives igh return high risk ow return low risk Provide yield Diversification potential Inflation linkage Private equity: Buyout Growth capital Venture capital Private debt: Direct lending ezzanine Special situations Distressed debt Venture debt Infrastructure: Core Value-add Opportunistic Infrastructure debt Source: PEQ = high = medium = low Notes: Assessments are for illustrative purposes only. Diversification potential is assessed against a portfolio comprising 50% global equities and 50% global government bonds. Inflation linkage assesses extent to which returns are correlated with the inflation rate. In further considering the risk-return characteristics of the various asset classes, Exhibit 3 below provides a sense of the return parameters both in terms of the absolute level and the dispersion of returns for these assets in comparison to public markets. 4
Exhibit 3: Illustrative dispersion of returns by asset class (2004-2016) 30% 20 10 0 Top decile 75th to 25th percentile range edian Bottom decile -10 Fixed income Equity Private credit Infrastructure Real estate edge funds Private equity Sources: BlackRock Investment Institute, with data from orningstar, Thomson Reuters and Preqin. Notes: The chart shows the distribution of historical returns net of fees for each actively-managed fund category relative to its median performance. Bond and equity funds are represented by all US-domiciled funds tracked by orningstar and hedge funds by the Thomson Reuters ipper TASS global universe. Preqin s global universe is used for private equity, real assets and private credit. Preqin data are internal rates of return. The investment model within Private Capital contrasts starkly with that applying for public investments, and many commentators hold this out as a source of alpha in itself. The fund manager within the PC model plays a very different role from that of fund managers investing in public shares and securities, generally leading the development of the value creation strategy to be carried out by a portfolio business and then directing its implementation. The fund manager will be centrally involved in selecting and changing the management team and working with the team to deliver the strategy for the business. See Private Equity an active investment model (PEQ, June 2017). In summary, adding Private Capital to a traditional public markets portfolio through isted Private Capital can broaden the opportunity set (by providing access to assets and investment strategies not found in public markets), boost return potential, enhance yield, improve portfolio diversification and provide some protection against inflation. isted Private Capital exists to enable public markets investors to invest in Private Capital through the stock market, thereby avoiding the regulatory and other barriers to access, as well as the complexity and illiquidity involved in undertaking Private Capital investment by the traditional limited partnership route. 5
Key investor considerations isted Private Capital acts as a bridge between public markets and Private Capital, enabling a public markets investor to invest in Private Capital through the stock market, thereby avoiding the regulatory and other barriers to access, as well as the complexity and illiquidity involved in undertaking Private Capital investment by the traditional limited partnership route. An PC company is a closed-ended investment company whose shares are listed and traded on an exchange, with associated governance obligations, including an independent board of directors. The company generally invests like a normal P in a PC limited partnership fund, with a professional GP managing the fund investments. PC companies operate in both direct investment and fund-of-funds strategies. ost PC companies own the investment assets only, but some are hybrid asset managers, where the listed entity also owns the management company. These companies tend to trade at higher valuations as the market usually attributes value to the management company in addition to the investment portfolio. Accessibility and liquidity The listed structure addresses the two main drawbacks of direct P investment: accessibility and liquidity. Access to PC limited partnership funds is severely restricted by a combination of large ticket size requirements, regulatory restrictions and complicated legal documentation. PC companies, on the other hand, are easily accessible and open up the PC asset class to the whole universe of public markets investors. The minimum investment becomes the price of one share, allowing smaller investors to take advantage of the diverse opportunities available across vintages, strategies, geographies and sectors. A listed investment offers daily liquidity. The shares of an PC company are traded on an exchange, giving the investment a clear valuation. Investors can manage their cash flows easily and avoid the funding risks and costs associated with a traditional P structure. There is still an indirect funding risk pertaining to PC investors as PC companies perceived as being overextended (i.e. having too many future commitments relative to a realistic realisation profile and cash reserve) can suffer a relative valuation discount. Dividends Some PC companies choose to pay dividends, often out of realisations, which is more akin to the way a traditional PC fund makes distributions. any PC companies pay regular dividends (for instance based on a percentage of NAV), which may appeal to multi-asset investors, although it is unclear whether this strategy is attractive to traditional public markets income investors concerned with dividend sustainability. This is because such distributions might still be viewed as being dependent on the environment for realisations rather than coverage by regular income. Share price premium / discount to NAV The shares of an PC company will trade in accordance with supply, demand and liquidity and so might trade at a premium or discount to NAV. Shares with poor liquidity will tend to trade at a structurally larger discount. It should be noted that the low frequency and lag in reporting of NAV by PC companies tends to increase NAV discount variability as the market moves up and down. In addition, PC managers tend not to adjust their multiple assumptions dramatically unless market multiples move significantly, and PC companies tend to be more financially leveraged than quoted market peers; both giving rise to variability between the share price and the latest reported NAV per share. 6
PC companies tend not to have explicit NAV discount management policies, but some have demonstrated a commitment to shareholder value through opportunistic buy-backs during periods of elevated discounts. Challenges for PC fund managers in launching an PC fund PC funds are generally based on the concept of blind pool investing and will often have an investment period of several years. Although the PC fund establishment documentation will set out the fund s investment strategy and restrictions applying, Ps generally give a wide degree of discretion to the manager in selecting investments. These factors can give rise to challenges for PC managers seeking to launch an PC company, since public markets investors have traditionally been uncomfortable with blind pool investing, usually preferring that the fund should have a seeded portfolio in place or should at least have identified target assets. In addition, because of constraints applying on the raising of share capital by companies seeking a listing, the extended investment period means that cash drag can be an issue. For P investors in PC funds this is avoided, since their commitment is typically to provide cash to the fund as and when required. In addition, realisation proceeds on the sale of investments are distributed promptly in order to maximise the fund s cash efficiency. 7
Conclusion The paper proposes that adding Private Capital to a traditional public markets portfolio through isted Private Capital can broaden the opportunity set (by providing access to assets and investment strategies not found in public markets), boost return potential, enhance yield, improve portfolio diversification and provide some protection against inflation. isted Private Capital exists to enable public markets investors to invest in Private Capital through the stock market, thereby avoiding the regulatory and other barriers to access, as well as the complexity and illiquidity involved in undertaking Private Capital investment by the traditional limited partnership route. 8
Appendix Summary of main investment strategies within Private Equity, Private Debt and Private Infrastructure Private Equity Private Equity investments span all stages of a company s life cycle, giving rise to a broader opportunity set than is the case with public markets. PE investments and fund strategies are usually classified into the following categories, with different investment models, investor cash-flow profiles and risk and return characteristics applying to each: Venture capital seed money and funding for start-up and early-stage businesses. Growth capital (also known as expansion or development capital) investment to help mature (usually) companies implement a growth strategy involving anything from capital expenditure to new product launches to acquiring another business. Buyout capital funding used to purchase a business or a division or subsidiary of a larger group Exhibit A shows PE AU by fund type as at June 2017 Exhibit A: Private Equity AU by fund type as at June 2017 ($bn) 179 385 Buyout Venture Capital 621 1,645 Growth Other Source: Preqin Fund strategies within Private Equity are many and varied, and would usually be defined by reference to type of investment (venture, growth, buyout), size of transaction or investment targeted (e.g. mega, large, middle market, lower middle market), geography (e.g. global, Europe), industry sectors and other characteristics (e.g. turnaround, distressed). Net return targets (i.e. after fees and carried interest or profit share) that PE funds use in marketing funds to prospective Ps will also be partially a function of the investment strategy being pursued. These will usually be specified in terms of net IRRs and net cash-to-cash multiples (or OIC multiple of invested capital); and would be expected to fall in the 15-30% range for net IRR targets and 2.0-3.5 for net cash multiples. 9
PE fund managers charge management fees of around 2% p.a. on committed capital (around 1% for fund-of-funds and secondaries funds) and receive a carried interest or profit share of 20% usually, subject to achievement of a hurdle return to Ps of around 8% p.a. Valuations of PE investments for the purposes of periodic reporting to P investors are generally by reference to International Financial Reporting Standards, particularly IFRS 13 Fair Value, and the International Private Equity and Venture Capital ( IPEV ) Valuation Guidelines. The latter guidelines were drafted to be compliant with IFRS 13. Fair value (defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date ) is defined by IFRS and the IPEV Guidelines outline the various methodologies that might be used to value investments. Valuations of PE investments held by PE funds can give rise to concerns for some public market investors seeking exposure to PE, but are arguably of less importance to P investors in PE funds, given their focus on long-term cashto-cash returns (see Key considerations for understanding isted Private Equity valuations, PEQ November 2016). Since PE valuations are based on subjective appraisals, albeit by reference to IFRS and industry guidelines, and come with a lag, the reported valuations are less susceptible to market swings than are public equities, meaning that the reported volatility of PE investments is often lower than that of listed stocks. This feature can be attractive to P investors, since lower reported volatility in valuations can reduce the likelihood of large reported losses on portfolios. Private Debt The global financial crisis provided a major boost to the growth of Private Debt on both sides of the Atlantic, but particularly in Europe. Exhibit B shows Private Debt AU by fund type. Exhibit B: Private Debt AU by fund type (June 2017) 11 80 Distressed debt 223 Direct lending 146 ezzanine Special situations Venture debt 178 Source: Preqin Private Debt funds raised $107bn in aggregate (136 funds) in 2017, a record for aggregate capital committed to the asset class. Of this, 51% was for Direct ending funds, 21% for Distressed Debt, 1% for Fund of Funds, 11% for ezzanine, 13% for Special Situations and 4% for Venture Debt. The various strategies within the PD universe reflect a range of differences across key investor preferences, mainly in terms of targeted return, risk and liquidity (including current yield). In choosing between different fund strategies, investors need to consider whether they wish to prioritise minimising risk or maximising returns and what their preferences are regarding liquidity. 10
Direct ending and ezzanine strategies sit at the minimising risk side of the spectrum; while Venture Debt, Special Situations and Distressed Debt sit at the maximising returns side. ost strategies within Direct ending and ezzanine target private equity-led leveraged buyouts as their main source of business. The senior part of the capital structure of a business is the bedrock of Direct ending, and most of the returns are generated from current cash pay coupons of a fixed credit spread and a fixed reference rate (usually ibor). Direct ending funds are sometimes geared at the fund level. ezzanine funds seek to make subordinated loans to finance buyouts or acquisitions, and generate their returns from current cash pay coupons in excess of 10% together with prepayment penalties and paid-in-kind interest, and occasionally might also be able to negotiate some equity participation through purchased equity or warrants. Direct ending funds typically have a fund life of 5-8 years, with an investment period of 2-3 years, typically. Targeted gross IRR returns at the fund level might be 6-10% p.a. (ungeared) or 10-15% p.a. (geared). ezzanine funds would typically have a fund life of 8-10 years, with an investment period of 3-5 years; and targeted gross IRR returns at the fund level of around 15% p.a. Special Situations investments are defined by Preqin as focused on event-driven or complex situations, where a fund manager may be able to exploit pricing inefficiencies due to an expected or actual significant event. The investor will typically restructure the company or resolve the complex situation in an attempt to restore the company s true value. Examples of investments of this kind include equity-linked debt, distressed debt, project finance, one-time opportunities resulting from changing industry trends or government regulations, and leasing. Distressed Debt strategies typically target mid to large cap companies and involves the purchase of deeply discounted debt securities, either on or off market. ost managers seek to generate returns through negotiation, using whatever leverage they have under the terms of the debt instrument and prevailing relevant bankruptcy law to drive a financial restructuring. Some managers base their return hypothesis on their view of a company s fundamental valuation, relying on catalysts, such as a refinancing or change in prospects, to drive value. Returns for Distressed Debt funds are often generated through a combination of a high contractual yield (since the debt is purchased at a large discount) and capital gain as debt prices recover or a restructuring takes place. Both Special Situations and Distressed Debt funds would typically have a fund life of 5-10 years, with an investment period of 2-4 years, and targeted gross IRR returns at the fund level of 15-18% p.a. Venture Debt strategies involve the provision of loans to start-up or early stage venture companies for working capital purposes, and usually involve the right to purchase equity in defined circumstances. anagement fees and carried interest arrangements within Private Debt are much more variable than within Private Equity (where the 2-and-20 model largely prevails). Within Private Debt, management fees can vary from 1% to 2.5% p.a. (with part sometimes charged on invested capital rather than committed capital); and carried interest rates can vary between 10% and 20%. In both cases, the lower rates would be more likely to apply to Direct ending and ezzanine funds. Private Infrastructure The Private Infrastructure industry has seen AU grow to $418bn at June 2017 from a level of $100bn at December 2007 (Source: Preqin). Drivers of this growth have come from both the demand side, as investors have increasingly embraced the emerging asset class due to its attractive investment characteristics, and from the supply side, as governments have increasingly resorted to private sector funding of infrastructure spending in the face of constrained budgets. Fund strategies within Private Infrastructure can be considered on various axes, the principal ones being Geography, Sector and the Core / Value-Add / Opportunistic risk-return classification. Geography is a significant consideration in infrastructure investing, due to differences in industry structures and conditions, finance markets and, most importantly, political and regulatory regimes. 11
Global funds invest in multiple continents, often with clear target allocations, while regional funds focus their attention on one continent or even one country. The majority of unlisted infrastructure capital remains focused on the developed markets of North America and Europe, as highlighted in Exhibit C below. Exhibit C: Private Infrastructure AU by Primary Geographic Focus (June 2017) ($bn) 44 61 179 North America Europe Asia Rest of World 134 Source: Preqin In terms of Sector, strategies can be specified as sector-diversified or sector-specific, with the former tending to be adopted by the largest funds seeking to take advantage of supportive trends in particular sectors on a dynamic basis. Sector-specific strategies would tend to apply to smaller funds emphasising the benefits of specialist expertise and experience and possibly looking to take advantage of longer term drivers within particular sectors (such as the growth of renewable energy within Europe). Infrastructure strategies are usually labelled as Core, Value-Add or Opportunistic (with a Core-Plus label sometimes sitting between Core and Value-Add) depending on their risk and return characteristics, with Core being low risk-low return and Opportunistic being high risk-high return, with Value-Add sitting in between. In addition, investors can invest in the debt side of infrastructure assets through infrastructure debt funds, which generally invest in subordinated infrastructure debt. A Core strategy would involve investing solely in assets with mitigated risks (e.g. fully constructed brownfield assets, with contracted or regulated revenue streams possibly correlated to inflation, low operational complexity, located in stable countries only). A Core strategy would be expected to target net IRR returns of 6-8% p.a., with a significant current yield component. A Value-Add strategy would have a primary (rather than sole) focus on assets with mitigated risks i.e. it would involve investment in mostly brownfield assets, but perhaps with a requirement for some capital expenditure; some investment in greenfield assets with limited construction and demand risk; a mix of short-term and longterm contracts; located primarily in stable countries; etc. A Value-Add strategy would be expected to target net IRR returns of 10-12% p.a., with a mix of yield and capital appreciation. An Opportunistic strategy would involve investment in assets with exposure to unmitigable risks (such as energy price changes, volume of road or ports traffic, emerging markets risk). Brownfield projects would involve exposure to market competition, revenues linked to demand levels and exposed to market cycles, without any contractual inflation-indexing. Greenfield projects would be undertaken, involving construction risk and without guarantees of demand levels on completion. An Opportunistic strategy would be expected to target net IRR returns of 14%+, with a large component of capital appreciation. 12
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