The challenges of investing in private equity were addressed at a recent event held at 300 N. Wacker and hosted by CFA Society Chicago’s Education Advisory Group. There are numerous issues that arise when making the decision to invest in the asset class. One of the biggest is regarding transparency. Investors typically do not have information on which companies they will be investing in but rather must put their faith in a fund that follows a certain strategy.
The basic characteristics of an investment in private equity are certainly more complex than an investment in the public market. The typical investor becomes a limited partner in an investment fund with a fixed term. A private equity firm will usually manage a series of distinct funds and will solicit new money as previous funds become fully invested. Funds can be capitalized by equity or debt; highly leveraged funds are LBO funds. Liquidity is limited compared to the public markets and investors that unexpectedly need cash may need to search for a buyer of their investment.
The event was organized into two panels on which six (6) investment professionals participated. The panelists were divided between asset managers, intermediaries and asset owners.
Panelists for Fund Managers and Intermediaries:
Tobias True, CFA – True is a partner on the Investment Strategy and Risk Management team at Adams Street Partners. He is responsible for portfolio construction and risk management as it applies to portfolios including commingled and separately managed accounts.
Josh Westerholm – Westerholm is partner in the Investment Funds Group of Kirk & Ellis. He is an attorney involved in forming and structuring private funds and advises clients with respect to regulatory exams and inquiries.
Panelists for Asset Owners:
Brad Beatty, CFA – Beatty is the chief investment officer at Sirius Partners LP. He is responsible for developing and implementing the firm’s investment strategy and oversees the firm’s investment in private equity.
Michael Belsley –Belsley is one of the country’s leading attorneys in the field of secondaries. His practice includes formation and governance of private equity funds (including primary interests in and secondary markets sales of private equity fund interests). He counsels buyers and sellers in their secondary market activities.
Harisha Koneru Haigh, CFA – Haigh manages the Private Investments and Real Asset portfolios for Northwestern University’s $11 billion endowment. Prior to joining Northwestern, she was a private equity manager at PPM America Capital Partners, LLC.
Bill Obenshain – Obenshain is chairman of the Advisory Board of the Center for Financial Services at DePaul University. Before joining DePaul, Obenshain spent 38 years in the financial services industry with Continental Bank and Bank of America. He is a member of the Economic Club of Chicago and the Chairman’s Circle of the Chicago Council on Global Affairs.
Each panelist gave a brief presentation and then answered questions from the moderator and the audience. The first panel featured fund managers and intermediaries and covered the following points:
What type of due diligence is performed on fund managers?
- Knowledge of historical performance is critical, as there is evidence that top quartile performance may be a good predictor of future performance.
- What were the drivers of past performance, what type of risks were taken?
- What were the sources of return?
- New investors need to know what type of valuation methods the fund uses. Most funds use a multiple of EBITDA to value potential investments.
What qualitative methods are used to evaluate funds?
- Does the fund have the infrastructure and back-office personnel to sustain itself across any cycle?
- What is the quality of the investment professionals making decisions for the fund and how are they compensated?
What are the challenges of creating a portfolio?
- A portfolio of funds can be diversified by geography, sector and fund size. Over time, different sectors fall in and out of favor. Investment dollars that are paid out over different time periods will aid in the diversification of return.
- Each investor will have a certain number of funds that they are comfortable investing in.
What is the risk of private equity with respect to other asset classes?
- Public equity influences private equity; however there is a much different risk profile. Limited liquidity, blind pool risk and higher fees demand that private equity returns be superior to public equity.
- Investments are made at intervals throughout the life of the fund; the timing will affect the IRR realized by the fund.
In the early days of PE, 25% to 30% returns were common; returns have dropped to the high teens. How does this change the risk assessment?
- Over the past 20-25 years there has been 10% annual growth in new dollars committed, this has compressed returns.
- There is a wide range of returns among funds and access to funds and managers who outperform can be constrained.
- Private equity funds must show performance at 300-500 bps better than public markets, LBO funds must demonstrate the highest performance premium.
What is a forever fund?
- A typical private equity fund may have a 10-year life, at which time capital is returned to the investor.
- There is very high interest from certain types of investors for longer terms from private equity funds. This is a better fit for institutional endowments and family offices needing investments for future generations.
What has been the trend in regulation?
- With the passage of Dodd-Frank in 2012, private equity is no longer the “Wild West”.
- Mandated registration has led to more oversight and enforcement actions are climbing.
- PE firms face more questions from regulators; there is a focus on marketing materials being truthful.
- More compliance personnel have been added, this is a positive for investors.
In the audience Q&A, the issue of risk was again addressed by the panel. True argued that risk can be defined by 1. Volatility (will it be lower?), 2. Fund Outcome (will return realized in 10-years be adequate?) and 3. Liquidity/cash flow (institutions have cash flow constraints that must be balanced with fund liabilities).
There was some audience Q&A with respect to the loosening of debt covenants and fee structure. Higher leveraged funds will be riskier and require a higher return. Historically, the fee structure has been 1%-2% of assets managed and a 20% share of profits at the back-end. The limited partnership agreement must be specific when enumerating fees (list it or lose it).
After a short break the second panel was convened. This panel was comprised of asset owners who were able to provide some additional perspective on the issues.
What kind of due diligence is done before investing?
- Haigh stated that 22% of Northwestern’s portfolio is in private equity. These are in co-investment’s with manager with which they have the highest conviction.
- Investors are under pressure to commit money to managers within a relatively tight-time frame as funds are closed to new investors quickly
- Staff resources are dedicated to getting to know the managers, those with a history of success are favored.
Now that all sectors are fair game for PE, how has the risk profile changed?
- The benefit has been the ability to diversify within this asset class. Different managers may specialize in different sectors.
- The challenge becomes “Which managers have the expertise for which sector?”
- PE firms with specialty funds in out of favor sectors still have to do deals; given the time-frame can they attract investment dollars?
- This trend reflects the maturation of the sector.
Given that the current part of this cycle has led to high valuations, what defensive measures do you take?
- Patience is needed, however when top quartile funds are raising cash, you need to invest if you have dollars to put to work.
- Investing consistently is important; timing the market is a mistake.
- Take advantage of secondary sales if possible.
In the audience Q&A there were several questions concerning currently inflated valuations among private companies and the paucity of investment opportunities because of over-valuation. Investors take comfort in PE firms who have followed companies for 3-4 years and use consistent valuation methods. The computation for EBITDA can vary among managers, the biggest error can be overpaying for an asset.