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What is the role of private equity in a private wealth portfolio?
Bizzozero: Private equity has evolved from what was a minority spot typically among North American endowments into a fully fledged alternative asset class. The trend has been driven by outperformance versus public markets. High-net-worth individuals are increasingly diversifying their assets into alternative investments, including private equity, as a way of improving the returns and diversifying the risk of their traditional equity and fixed income portfolios. In general, investments in private equity are appropriate for investors who are taking a medium- to long-term view and are willing to accept illiquidity in return for potentially higher returns.
What are the benefits of adding private equity to a portfolio of traditional asset classes of stocks and bonds?
The main benefits are the potential to enhance returns and increased diversification.
The main reason to invest in private equity is very simple and it is to achieve high returns. Over the long-term, returns of private equity have shown to outperform public equities. This has been the case in the US and in Europe over the past 10 years where average private equity returns have outperformed public equities by approximately 400 basis points. That ought to be a good reason alone to be in the asset class and this gets significantly better by investing with top quartile managers who have outperformed by a much wider margin of approximately 2,000 basis points annually.
Private equity has been demonstrated to provide the benefits of diversification due to the low level of correlation with other traditional asset classes. Adding 5% to 10% exposure in private equity to a portfolio tends to increase the expected returns and reduce risk.
Is the private equity environment much more challenging now?
Average private equity returns will come down a bit. Also it may be harder to exit the transaction as quickly as before and the ability to refinance quickly may not be as readily available. The most important thing to remember about private returns is that the reason people invest in private is not because private equity firms are guaranteeing a 25% rate of return but because they have concluded that the gap between what they can get by buying letÆs say an S&P500 index and what they can get from a top quartile firm is so large that illiquidity and higher fees are worth it.
What are the reasons for private equityÆs outperformance over public equities?
Access to legitimate inside information prior to making an investment, high degree of control and influence over investments, and strong alignment of shareholder and management interests.
When evaluating the merits of making an investment, private equity managers are generally afforded fuller access to company management and information. This type of access and information can prove quite valuable when determining a company valuation and the timing of making an investment. This greater level of disclosure contributes significantly to reducing risk in private equity investment. Equivalent information in the public markets would be considered inside information. Therefore, by definition, investors in public markets will know less about the companies in which they invest.
Private equity managers usually acquire majority stakes in their portfolio companies and have the opportunity to influence a portfolio companyÆs management and strategic direction.
Private equity managers do seek absolute returns and their traditional incentivisation structure, the carried interest (traditionally a 20% performance fee), is highly geared towards achieving net cash returns to investors. There is therefore a strong alignment of interests between shareholders and management which is very much triggered on exit and which you do not have by investing in public equities.
What should investors be looking out for when buying private equity?
The wide dispersion of returns in private equity highlights the need for a professional approach to the selection of funds. In this regard, it is important for private banks to provide the best of breed private equity investments to their clients û where success depends on the bankÆs ability to identify and gain access to the best fund managers.
Since it is not possible for many private individuals or high-net-worth individuals to secure a diversified exposure to a variety of funds, bearing in mind the minimum commitment size to private equity funds (usually in the range of $10 million), these individuals will potentially be able to access private equity investment opportunities via dedicated feeder vehicle structures which provide exposure to few pre-selected top tier private equity managers with a proven track record at a much lower minimum investment level (usually $250,000).
Theoretically, private banks will provide their clients the opportunity to build a diversified private equity portfolio over time focussed on a specific strategy (buyout, distressed, growth or venture capital) or geography (such as the US, Europe or Asia) of the private equity market. Since 2004, Deutsche BankÆ private equity investment programme for private banking clients has structured eight offerings worth a combined $3 billion raised worldwide, including a fifth from Asia.
What are the potential investment opportunities?
The current market conditions are creating enormous potential investment opportunities in private equity. It is during these disruptive periods when private equity typically makes its best performing investments and investments made in 2008 and 2009 could likely prove to be some of the most profitable vintages. As a result of the current market environment, Deutsche Bank Private Wealth ManagementÆs investment activity, manager due diligence and selection will focus on top tier managers, specific sectors and sources of return and ability to adapt.
What are you looking for in the managers?
Avoid broad diversification: Diversification is the enemy of high returns in private equity. Private Banks should not be looking to build broadly diversified private equity portfolios. This would at best generate average returns which are usually few basis points above public equity returns.
We are looking to build û through our private equity investment program of two to three private equity products per annum û a portfolio of 25 to 30 top tier managers investing across different industries, different regions (US, Europe, Asia) and different strategies (buyout, distressed and growth capital). As the performance gap between top and bottom quartile managers will remain significant and widen, we believe that a concentrated portfolio of 25 to 30 premier managers built over three to four years offers the greatest opportunity for outperformance.
In which sectors do you see compelling opportunities?
Distressed assets, Asia, and energy.
Similar to both the early-1990s and then the early-2000s, the current severe capital market dislocations will create compelling opportunities to invest in good companies which are available at significant discounted levels.
We continue to believe that the fundamentals within the Asia private equity market are very attractive. The market has evolved and matured since the financial crisis of 1997 with larger control transactions becoming more usual and exit more commonplace. As macroeconomic investing in the region remains strong, private equity is an excellent way through which one can potentially invest in the regionÆs growth, particularly in comparison to the public markets.
Energy is an industry in transition and the current transformation is creating market inefficiencies and dislocations that require significant capital investments. We see compelling investing opportunities both in conventional energy as well as in renewable and alternative energy industries and believe that private equity firms are very well positioned to play a very active and opportunistic role in the ongoing restructuring of the conventional energy industry and to benefit from the growth of the renewable and alternative energy.
What factors do you look at when analysing a private equity firmÆs source of returns and ability to adapt?
We believe that not all returns are created equal from a risk-adjusted standpoint and it is therefore important to understand the sources of the equity value creation on which an investment relies. One really needs to dig down to sort out the source of returns:
How much success is due to manager skills versus the rising tide of a good economy and great capital markets?
Around 80% of private equity deals in the past 30 years were made in favourable environments. Has the PE firm we are looking at invested in period of tight credit, recession, macroeconomic stress?
Potentially, an individual can make money in private equity in three ways: leverage, multiple expansion and operational improvements. We see little potential for multiple expansion and the leverage scope will decline. However, the scope for operational improvements remains high across the globe. Our future investment activity will focus on private equity managers with a proven track record in generating superior value from operational improvements across different economic cycles and not rely on the positive developments of the capital markets. Future returns will be driven by operational improvements rather than multiple expansion and leverage.
The September edition of AsianInvestor magazine contains a feature on private banking trends in Asia.
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