Private Equity June 2002 Volume 4 Issue 4 I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years. Warren Buffet, as quoted in Fortune Magazine Value Added A Product of the MOSERS Investment Staff A Newsletter for the MOSERS Board of Trustees In this Issue of Value Added we will address the subject of private equity as an investment opportunity and how it differs from investing in the public markets. We will define private equity, describe the process of investing in private equity, and explain why we believe an investment in this area could now make sense for a long-term investor like MOSERS. Why Private Equity Might Make Sense Today Private equity is an area that MOSERS has avoided in the recent past, primarily because of: (i) bad experience in the late 1980 s with mandated investments in this area, and (ii) a belief that returns needed to fund the plan could be achieved through the public markets without exposing the system to the potential negatives associated with investment in private equity, which we will describe later in more detail. Today, given expectations for lower than historic average returns from investments in the public markets, the additional returns and diversification benefits from private equity appear more attractive. At a theoretical level, it makes financial sense for private equity to offer higher returns than public equity for several reasons. First, private equity is illiquid. Once an investment is made, it is very difficult and expensive to get out of the investment in the short term. It makes economic sense that this lack of liquidity should provide a return premium over more liquid investments. Second, private equity has a higher level of bankruptcy (default risk) than is seen in the public markets. We often use the S&P 500 to represent the public market which is made up of some of the largest and best known companies in the world. The average person would probably not recognize any of the names in a private equity portfolio. While most of these companies will never become household names, some will grow and become widely recognized. As a rational investor, would you require a higher return from an investment in McDonald s or from an investment in Mac s Cafe? Due to the additional risk involved with new smaller companies, a return premium should be expected. In our asset allocation work we have modeled private equity with an expected return of 11.50% and a standard deviation of 25%. That is 300 basis points above the return modeled for the S&P 500 index with a standard deviation that is 900 basis points higher. We believe that these returns are what should be expected from a program that is in the top quartile of the private equity universe. In our opinion, if a private equity program is only going to produce average results, it does not make sense to take on the additional risks associated with the asset class.
We believe that MOSERS has some advantages that should allow for establishment of a top quartile program. Our governance system allows us to move more quickly than many public funds. Since top managers have no trouble attracting capital, the manager could be closed to further investments by the time the decision is made if the decision making process takes four to six months (which is not uncommon in the public sector). Under our current structure, decisions can be made in a much more timely fashion. Our size is another advantage relative to some of the much larger pension systems. We do not need to place massive sums with individual managers in order to acquire meaningful exposure. It makes it easier to get access to the desired managers if you are not trying to consume all of their capacity. Our relatively small size also allows us to get to a target allocation in a reasonable amount of time. A five percent allocation is the smallest that we would recommend. It is expected that we could have this amount of money committed to managers in about five years. Private equity would start to be a meaningful component of the portfolio in six to eight years. Many larger funds have not been able to get more than two to three percent committed in their programs and it is our belief that private equity cannot have a meaningful impact at such low percentages. After five years, we would propose a formal evaluation of the private equity program with the intent to take the allocation to ten percent or begin to phase it out, depending on the circumstances at that time. What is Private Equity? The term private equity is used to describe several types of investments. For the purposes of this newsletter the term is being used to describe equity investments in companies made through means other than the public stock markets. The primary areas we will consider here are venture capital and buyouts. Venture Capital Venture capital involves making investments in young, relatively small and rapidly growing companies. Within venture capital, investments can be made at different stages in the life of the company. Some investments are made in companies that consist of only an idea, no product, and few if any employees. In other cases, the investment is made to help a company expand or grow a product that is already being produced and marketed. It can often take a number of years before an investment shows positive returns. A number of the companies that receive financing will end up failing and all of that money will be lost. In some cases a company will require additional funding after the initial investment. These secondary investments may be as risky as the first round because the company may be struggling and near failure. In such cases the investor will need to decide whether to provide the additional funding or allow the initial investment to be lost. Venture investing is the more risky area of private equity due to the fact that the investments are often made very early in the life of a business when the ultimate fate of the company is far from certain. While not perfect, the best comparison of this type of an investment relative to what is available in the public markets would be investments in microcap growth companies. Buyouts Buyouts involve the purchase of a company or part of a company. Buyouts can involve companies ranging greatly in size where only the very largest companies are excluded from such opportunities. There are a number of scenarios in which a buyout makes sense. In some cases original owners have depleted their capital and need to bring in outside investors to allow for continued operations. Sometimes a large company will want to sell a division that no longer fits the strategy of the parent. Managers of the unwanted division may look for financial support from outsiders to provide the resources needed to complete the purchase. Another situation that might create a buyout opportunity would be industry consolidation. In this case the management of a company in a particular industry will team with a financial backer to buy other small companies in the same industry with the idea of becoming a major player in the industry. Like venture capital, buyouts can also take a number of years before the value of the acquisition is realized. While not perfect, the best comparison of this type of an investment relative to what is available in the public markets would be investments in value companies. With both venture and buyouts, investors receive ownership rights and the transaction takes place outside of the public stock markets. Structuring a Private Equity Portfolio A n investor in private equity can construct a portfolio which, much like a public market portfolio, can be tailored to the investor s risk and return requirements the more venture capital that is included, the higher the risk and expected return of a portfolio. An institutional portfolio can be constructed with little or no venture capital. Venture capital can be divided into subclasses differentiated by the life stage of the investments. This allows an investor to exclude early stage venture capital if the risk in that category is something the investor does not care to take on. Buyout can also be divided into classes with differing levels of risk and expected returns. By combining the various segments, a diversified private equity portfolio can be constructed to meet the investor s desires. It is not possible to develop a private equity portfolio as precisely as a public market portfolio can be structured with regard to expected risk and return. The illiquidity of the private markets makes hitting precise targets impossible. Ranges must be developed and managers will work to keep the portfolio within these ranges. This illiquidity also makes rebalancing at the total fund level a more difficult task.
Investing: Public vs. Private It is relatively simple for MOSERS to invest in the public markets. A search is conducted to find a manager who excels in the target investment area. Such a manager s performance can be measured against a variety of published benchmarks. By studying a number of managers we can select one who we believe will provide acceptable performance for the specific equity assignment. We are then able to monitor the manager s decisions, down to and including the actual holdings in the portfolio, including purchase and sale decisions. Within a few days after the end of a month we are able to judge the performance of the manager for that month. If a decision is made to terminate the manager it takes only a matter of hours to complete the termination. If warranted, the stocks could be sold by the system and converted into cash within three days. In the private markets, termination of a manager is not as easy and efficient. Over relatively short time frames, defined as three to five years for purposes of this discussion, there are no good benchmarks for private equity. As the time period begins to lengthen beyond five years, we can begin to compare our results to the results of other managers and to a benchmark like the S&P 500 plus a premium for the illiquidity risk. For example, one might use the S&P 500 plus 3.0 percent as a measure of success. There is an issue of survivorship bias that needs to be taken into account when comparing returns of a portfolio with the returns of other managers in the same discipline. If a manager goes out of business because of poor performance these results are lost. The companies that make up a private equity benchmark are constantly changing, therefore, it is tough to draw apples-toapples comparisons. Also, because managers are in a position to not report poor results, reported performance results tend to get skewed upward. These are just two examples of the benchmarking problems associated with an investment in private equity. It is very difficult if not impossible to compare managers of private equity and there are a number of reasons for this shortcoming. The time period for evaluation itself presents a problem. The way managers invest in private equity is by forming limited partnerships. These partnerships have varying life-spans that might range from five to fifteen years. The manager finds businesses to invest in during the first three to five years and then these investments are allowed to run their course for the next two to ten years. As the investments are sold or converted to public equity, the money is returned to the investor. It is possible to compute an internal rate of return (IRR) for the investor over the time period in which the money was invested. However, in most cases it makes little sense to compare these results to any index that reports the return of the average private equity fund over the time period. Comparing an IRR for an investment with the annualized return of an index is not an apple-to-apples comparison. The IRR measures only the dollars actually at work, so it can give a tainted view of the investment return. It is also more difficult to group managers based on the investment style or areas of the market in which they function. Many investors with private equity allocations have chosen to judge the performance of such portfolios by drawing comparisons to some derivative of a public equity benchmark. For example, a benchmark of the S&P 500 plus something in the range of 300 or 500 basis points is fairly common. This makes sense because it should be expected that over long periods of time private equity will provide some premium over what is available in the public markets. The J-Curve I t is almost certain that the return for a limited partnership will be negative in the early years. Money will be invested in businesses that are just getting started and the companies that are not going to succeed will probably fail during the first few years. In addition, money management fees must be paid regardless of whether or not income is being received. All of these things contribute to losses which should be anticipated during the first few years of a partnership. This effect is referred to as the J- curve. If you graph the performance of a partnership you expect the graph to look like the letter J. Losses in the early periods are followed by very positive returns in the later years. Returns for the partnership in any calendar year will be very dependant on the life-stage of the partnership. The graph below shows how the returns of a partnership might look. As you can see, the returns for the early years are much different than those in the later years. This also makes it difficult to compare managers. 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% 1 2 3 4 5 6 7 8 9 10 Drawdowns Distributions Cumulative Cash Flow
The Exit Strategy Akey element in private equity investing is the exit strategy. The investors in private equity partnerships do not wish to hold the position indefinitely. To cash out there needs to be a buyer for the now successful companies. In the recent past the exit strategy has been the Initial Public Offering (IPO) market. During the late 1990 s technology companies were being taken public at a rapid pace. The markets were paying incredible amounts for companies that, for the most part, were not making a profit. This market encouraged private equity partners to bring companies to the market as quickly as possible. Since the beginning of the stock market correction, the IPO market has been closed for the most part. This has required partners to delay bringing companies to the public market or to look for other exit strategies to unlock value. One avenue has been to sell interests to large companies or to other private equity funds. Top Quartile Managers As might be expected, in private equity there is a great deal of dispersion in the performance of managers. This dispersion can be explained when you consider how a manager seeks return. For the most part, in the public markets any manager can hold any stock desired and the past performance of all the stocks is information that is readily available. Public market managers can mimic the actions of other successful managers and the benchmarks. With private equity, managers will often take the entire equity position available in a particular company. This means that others are unable to share in this investment. In the private equity world this is called deal flow and it is the lifeblood of a private equity manager. If a manager is not seeing deals until others have passed on them, it is almost impossible to be a top performing manager. Managers also have to be able to negotiate favorable terms for the deals. A great idea may not be a great investment if the manager pays too much on the front end. A manager will probably invest in fewer than five out of each 100 opportunities that are presented. The ability to pick the winners is critical. A public equity manager can get out of an investment at any time if markets or conditions change but the private manager does not have that option. The private equity manager must also be able to decide how long to stick with an investment that is losing money. In the public market a manager has the chance to get out at any point. For example, if a stock is purchased at $10 and the stock drops to $9, the stock can be sold at that point. If a private equity manager puts $1,000,000 in a new company there may not be a chance to take $900,000 and get out. More than likely the manager will have to ride the investment down until some event, such as a buy-out or IPO, provides liquidity for the investment. A manager has to be willing to pull the plug on an investment that is not going to make it and be insightful enough to know the difference between investments that deserve additional funding and those that do not. This requires managers to be able to make the difficult decision of writing off all the money that has been invested in a particular venture up to that point. If a manager is not able to do this, they continue to send good money after bad in an investment that is just not going to survive. At the same time the manager needs to be able to infuse additional funds if the company can make it and just needs more time and money. The ability to distinguish between the two is critical for a manager. Management Fees As you might expect, the fees that private equity managers and general partners receive for their services are considerably higher than one expects to pay public market managers. In nearly all cases there is some sort of profit sharing involved. A common fee structure is a 1% management fee on committed capital plus 20% of the profit. The profit sharing helps to align the interests of the manager and the investor. Although this is very high in comparison to what is paid for public market management, it appears that the private equity market is one in which there is a definite advantage for the experienced managers. There is also no easy way to index or passively get exposure to the asset class. All of the evidence available to us suggests that institutional investors wishing to participate must accept high fees as simply being the cost of doing business in the private equity market place. How MOSERS Can Invest In Private Equity Based on our research, we believe there are a couple of viable alternatives for developing a MOSERS private equity investment program. One option would be to hire a consultant to advise us in the investment process. The consultant would help devise and implement a plan and suggest managers for us to use. In this case, it is likely that the consultant would participate with staff in the hiring and firing decisions, as is now the case with public market managers. This means that MOSERS staff would need to be positioned to act as a fiduciary and perform due diligence on all managers being considered. Staff would also need to do all the legal and paper work involved in the investments. The best known consultants in this area maintain that, in part, they add value and are needed because of their access to the top managers in the private equity arena. Alternatively, MOSERS could hire a discretionary manager or investment advisor. Such a manager would actually make all the investments for MOSERS. The manager would work with staff to develop a plan and then they would implement this plan. MOSERS staff would have oversight responsibility only; the manager would handle the legal matters and paper work. This would be similar to the way we hire existing asset managers we hire the advisor and they select the investments. Instead of selecting stocks, the private equity managers would select the businesses to own.
THE ISSUES THAT MERIT CONSIDERATION Pros of Private Equity Enhanced Returns Private Equity investments, because of their illiquid nature and higher default rates, should allow long-term investors, such as MOSERS, to generate returns in excess of those expected from public market investments. Governance Issues Our relatively small size and progressive governance practices give the fund a distinct advantage over many other institutional investors, which will increase the odds of building a top quartile program. Correlation Benefits A portion of the return from private equity comes from the skill added by the manager in guiding the companies through the early growth stages. This means that the returns will not be highly correlated to the public markets. Cons of Private Equity! Mitigating the Cons Illiquidity Issues The long-term nature of the investments can cause problems. The investments are difficult, if not impossible to value during most of the investment cycle. Rebalancing becomes difficult at best. It can take many years to get allocated dollars invested.! Understanding the true long-term nature of these investments will help investors stay the course to reap the benefits. Accessibility Issues The top-tier managers have no trouble attracting capital; therefore, they can be picky about selecting investors. These managers can also charge higher fees because their services are in demand. Without access to top-tier managers an allocation to private equity becomes unappealing from a risk/return perspective.! Work with a consultant/manager that has existing relationships with the top-tier managers. Fees The fees involved with investing in private equity are high. General Partner s (GP) fees start at 1% plus 20% of the profit. Consultant/manager fees will add an additional 50 basis points.! Align interest so that the GPs and the consultants/managers only benefit if MOSERS benefits. Resource Issues A private equity program will be a large drag on resources. It is likely that up to one FTE should be committed to a private equity. Staff retention may become more difficult as experienced private equity professionals are in high demand.! There must be a willingness to commit resources to hire and adequately compensate private equity staff. Economically Targeted Issues Historical experience suggests that if political and geographical restraints are put on the private equity program, lower returns and higher risk will result! A private equity program, if implemented, must have the same governance standards currently in place for the rest of the MOSERS portfolio
Conclusion In this issue we have attempted to describe private equity investing. We hope we have adequately conveyed the fact that investing in private equity is very different from the public markets in which we have traditionally invested. With our expectation of lower returns from the S&P 500 going forward there may be a place for private equity in the MOSERS portfolio. We believe MOSERS has a much better than average possibility of being successful in this area because of our relatively small size and our governance structure. However, we must also add the caveat that there would be a high probability of failure if the program is not free from artificial barriers such as geographical preferences and political influences. The program will only meet the requirements of the system if it is a top quartile performer. In order to achieve this goal, we must be able to find and fund the best managers in the sector. Before embarking on such a program, the board would need to get comfortable with the fact that, during the first few years, reporting on performance will make little sense. It will be a number of years before the returns from the program exceed the fees paid. This is a long-term commitment that would probably not make sense at anything less than five percent of the total portfolio (with the likely prospect of increasing that amount). Once the commitment to a manager is made, the money committed will probably not be available for other uses for eight to twelve years. In spite of the caution flags offered here, an allocation to private equity may still make sense for MOSERS. For such a program to be successful it is crucial that it be implemented with emphasis on practices that will result in top quartile private equity performance. This newsletter will be produced and distributed in advance of each scheduled board meeting with the objective of educating the Trustees regarding investment issues facing the pension fund. If you have questions or would like additional information on any topic contained herein, please contact the investment staff. MOSERS Investment Staff Rick Dahl Chief Investment Officer 632-6160 Jim Mullen Portfolio Manager Fixed Income 632-6164 Pat Neylon Portfolio Manager Equity 632-6165 Tricia Scrivner Investment Officer Fixed Income/Cash 632-6161 Meg Cline Investment Officer Equity 632-6144 Cindy Rehmeier Jr. Investment Officer 632-6147 Shannon Davidson Operations Officer 632-6166 Karen Holterman Junior Operations Officer 632-6163 Jessica Hjelvik Executive Assistant 632-6162