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  1. 1. rivate equity 8/11/01 10:31 AM Page 1 JULY 2001 PRIVATE EQUITY A GUIDE FOR FINANCIAL PLANNERS
  2. 2. rivate equity 8/11/01 10:31 AM Page 2 Colonial First State Investments Let the Fund begin. The Colonial First State Diversified Private Equity Fund Please read the important information about Colonial First State and the Colonial First State Diversified Private Equity Fund on page 4.
  3. 3. rivate equity 8/11/01 10:31 AM Page 3 PAGE 3 Contents 4 The argument for private equity Australian investors have been relatively slow to get into private equity, but the potential benefits for investors and the broader community of an allocation is a powerful argument in favour of the fledgling asset class. 7 The rich history of the Australian private equity industry Retail investors played an important part in the beginnings of the Australian industry in the mid 1980s, but until recently wholesale investors have dominated as the industry has matured. 14 Colonial sets sights on record retail raising Colonial First State is aiming to raise at least $150 million from the retail market for its private equity fund, which would make it the largest ever retail fund raising in Australia. 16 A dash of private equity increases portfolio resilience Research by consulting firm van Eyk suggests a 10 per cent allocation to private equity spread across a number of managers can have a strong positive diversification effect for a portfolio. 18 Growing options in retail private equity market In the past two years the retail private equity market in Australia has seen a growing number of managers enter the fray, from large institutions like JB Were and Macquarie to new boutique partnerships like Crescent Capital Partners. 20 US appetite for private equity undimmed by excesses of tech wreck The US private equity industry has endured a difficult year after the excesses of 1999 and 2000 but investors continue to flow into the asset class based on the strong return history of the world’s largest private equity market. 22 Finding a partner key to venture capitalist fortunes Because of the unlisted nature of private equity, and especially at the early stage, venture capital end of the market, finding a good deal is the key to success but it is far from a smooth process.
  4. 4. rivate equity 8/11/01 10:31 AM Page 4 PRIVATE EQUITY By Martin Lawrence The prime of local private equity still to come The arguments for venture THE arguments for venture capital and private equity are both emotional and capital and private equity financial. On the emotional side of the ledger, the oft-heard criticism of Australia from entrepreneurs and scientists is that the country produces great ideas, but are both emotional and developing them within Australia is difficult. financial. On the emotional Executive director of the Australian Venture Capital Association (AVCAL), side of the ledger, the Andrew Green, says Australia remains a relatively under-developed market when oft-heard criticism of it comes to private equity, but the potential returns are enormous. “Australia has Australia from entre- very high quality human capital and as a result we have all the makings of very high returns,” he says. One way of looking at the potential remaining in the preneurs and scientists is private equity market is to compare the amount of funds committed to the sector that the country produces with the situation overseas. great ideas, but developing Head of private equity at JB Were Investment Management, Bernard Stanton, them within Australia says Australia has about 1 per cent of total GDP committed to the sector is difficult. compared to 3 per cent in the US and 5 per cent in Europe. AVCAL says $831 million was raised in Australia in 2000 for private equity, compared to about $133 billion in the US, which even allowing for the difference in the size of the two economies leaves Australia relatively under-invested in private equity. As proof of Australia’s untapped potential, Green points to the 2500 science- based PhD’s within the CSIRO, an organisation now working hard to commercialise its technology. And that’s just at the venture capital end of the market. Like listed asset LIKE listed asset classes, private equity has a variety of manager types, with classes, private venture capital sometimes used in Australia as an umbrella term. More usually equity has a variety venture capital means early stage investing in companies with little cash-flow, of manager types. which need money to make their ideas commercially viable. Because of the potential for growth, it’s a sector that can produce remarkable returns, although it is riskier than later stage investing. Development and expansion capital managers invest in profitable existing companies, which are looking to expand within Australia or overseas. Then, at the most developed stage of the market, are management buy-outs (MBOs). Important information Investments in the Colonial First State repayment of capital. Investments in the fund Diversified Private Equity Fund, a registered are not deposits or other liabilities of CBA or its about Colonial First State managed investment scheme (ARSN 096 425 subsidiaries, and investment-type products are and the Colonial First State 302), are offered by Colonial First State subject to risk including loss of income and Investment Managers (Australia) Limited ABN capital invested. Diversified Private Equity 98 002 348 352 (‘Colonial First State’, ‘CFS’). This guide provides general information Fund. CFS has appointed Colonial First State Private only and does not take into account individual Equity Limited ABN 98 002 642 819 to manage circumstances. Past performance is not an the Fund. indication of future performance. CFS is a subsidiary of the Commonwealth The offer for units in the fund is made in the Bank of Australia (CBA), which does not current prospectus and applications can only guarantee the performance of the fund or the be made on the form contained in it.
  5. 5. rivate equity 8/11/01 10:31 AM Page 5 PAGE 5 MBOs are a staple of the European private equity market, and are deals where a large company spins out a division of its operations which is under- performing. Its management team, with assistance from a private equity manager, then tries to improve its performance. Green says both sides of politics in Australia remain committed to improving the environment for private equity, especially at the venture capital end of the market. “Both sides of politics realise that if we’re going to have long-term wealth creation in Australia, we’re going Green says both sides to need to develop intellectual capital, no question,” he says. of politics in Australia In January, Prime Minister John Howard announced the Government’s remain committed to Backing Australia’s Ability package, which boosted funding not only to research improving the but also to programs designed to commercialise research. The Opposition’s environment for commitment to encouraging private equity in Australia is also clear, with Labor private equity. supporting capital gains tax cuts in November 1999 designed to encourage investment in venture capital. BUT regardless of national benefits, the chief concern of a professional financial advisor advising clients on investment is how that investment will perform. Green is confident the numbers for private equity in Australia make a convincing case for investing in the sector, especially when its benefits as a portfolio diversifier are taken into account. “It is a long term investment and in many respects it is counter-cyclical, especially at times when public markets are down,” he says. Because the Australian market is still quite young, and because of the long-term nature of the investment – most private equity funds have a 10 year life span – performance data is still sketchy, simply because very few funds have been totally wound up and returns distributed to investors. The other difficulty with private equity returns is in comparison. Because a private equity fund is raised and Andrew Green then closed to new investors, the year in which the funds are raised – known as Executive director of the Australian Venture Capital Association (AVCAL) the vintage year – has a major impact on returns. This is because the price paid to fund the companies and entrepreneurs a manager invests with differs with market conditions. For example, Technology Venture Partners executive director John Murray, Companies are more one of Australia’s most experienced venture capitalists, expects the cost of deals likely to spin out in the information technology sector of the market to fall for his firm’s third businesses in tough fund, because of the tech wreck fall-out. Similarly, private equity managers who times, and less likely invest in later stage companies can find good opportunities in poor economic to demand top dollar conditions. for them. Confronted by the need to improve balance sheets, companies are more likely to spin out businesses in tough times, and less likely to demand top dollar for them, allowing private equity managers to fund an overhaul of the new company.
  6. 6. rivate equity 8/11/01 10:31 AM Page 6 PRIVATE EQUITY IN association with Venture Economics, AVCAL produces annual figures on the performance of Australia’s venture capital and private equity managers, as well as the total amount of money invested into the sector. Those funds that began investing in 1996 have produced an average annual internal rate of return (IRR) of 19.8 per cent to date, although an IRR does not necessarily include exits from investments, where the company has been sold or listed on the stock exchange. These figures, which don’t include manager fees because fees are difficult to calculate until the fund has been wound up, are almost within the typical target returns of 20 to 25 per cent per annum – and IRR’s tend to increase as a fund goes on. For example, the average IRR of the 1996 vintage year funds at the end of 1998 was just 5.4 per cent. Many private equity managers are sceptical of IRR figures – the saying goes, Those funds that “you can’t eat IRR”, – preferring to rely on figures based not just on portfolio began investing in earnings from companies, but also from the final figures after the investments 1996 have produced have been sold or listed. an average annual Private equity and venture capital managers are even more obsessed with internal rate of return performance than traditional managers, because most private equity managers (IRR) of 19.8 per cent make the bulk of their earnings from performance fees, known as carry fees, to date. which are calculated as a percentage of their funds’ final performance. THE best Australian private equity fund of vintage year 1996, as measured by AVCAL and Venture Economics, has an IRR to date of 36.3 per cent. Unlike in active equities or fixed income management, where the difference between the top and bottom quartile is usually about 2 per cent, in private equity the difference between the top and bottom returns is huge, meaning a quality manager is capable of producing stellar returns. But although the return difference can be daunting, AVCAL’s Green says the Australian private equity industry now, after five years of steady growth, has a solid pool of skilled managers and management teams. “We do have a very sound base from which to go on ... and we’ve now got a critical mass of capital,” he says. s The Growth of Private Equity in Australia Year Amount of Amount of Capital Raised ($m) Capital Invested ($m) 1996 103 186 1997 409 309 1998 266 221 1999 812 405 2000 1197 832 Source: Venture Economics/AVCAL
  7. 7. rivate equity 8/11/01 10:31 AM Page 7 PAGE 7 By Victor Bivell The rich history of Private Equity in Australia – 1984 to today THE growth of investment opportunities for retail investors in unlisted private equity vehicles is one of the more interesting developments in a private equity industry that is now growing in every direction. While some people may think the retail market for private equity has only just begun, the fact is that retail investors have always been part of the industry. They were among the industry’s founding investors, and unlisted retail funds were among the industry’s first vehicles. But until now their development has taken third place behind unlisted wholesale vehicles and listed retail vehicles. For most funds managers the main game has always been institutional and professional investors, with the retail sector looked after by a small number of Victor Bivell is the founder and publisher managers with relatively smaller, mostly listed, retail funds. of Australian Venture Capital Journal Two big changes have picked up the pace of retail unlisted growth in the last and Australian Venture Capital Guide. two years. These have been a small but significant increase in the number of See private equity managers specialising in the unlisted retail market, and some clever structuring by intermediary institutions to create unlisted retail vehicles that can invest in and alongside larger wholesale funds. But these changes were a long time coming. MIC Program THE first unlisted retail vehicles were set up in 1984 as part of the Federal The first unlisted Government’s Management and Investment Companies (MIC) program, generally retail vehicles were held to be the formal start of the venture capital industry in Australia. set up in 1984 as part This scheme was targeted at retail investors, offering 100 per cent tax of the Federal deductions for investments into the small group of licensed MICs. Ultimately, 14 Government’s MICs were licensed and these raised a total of $374 million. Management and The very first MIC was, appropriately enough, First MIC Ltd, an unlisted retail Investment vehicle that later changed its name to Hambro-Grantham Capital Ltd. It is also Companies (MIC) one of the few former MICs to have made it to the 21st Century. program, generally Established and managed by Hambro-Grantham, it recently became part of held to be the formal the Colonial First State Private Equity stable and still has a substantial portfolio start of the venture and a history of many dividend payments. capital industry in Other former MICs to have survived to this day are the listed companies Australia. Continental Venture Capital Ltd and Australian Innovation Ltd, then known as BT Innovation. The MIC Program encouraged other non-MIC private equity groups to set up and in 1987 the first management buyout funds were raised: the Byvest Equity Fund and Byvest Mezzanine Fund and the Fulcrum Two Management Buyout Trust.
  8. 8. rivate equity 8/11/01 10:31 AM Page 8 PRIVATE EQUITY The MIC program had mixed fortunes and was closed in 1991. While it helped set up the first group of private equity managers, funded many technology companies that are now well known, and was a catalyst for the establishment of non-MIC private equity investment companies, the bottom line is that many investors in the Program lost money. This held back the development of the private equity industry during the late 1980s and first half of the 1990s. The Money Drought In the “flight to THE groundwork for the fall was laid by the inexperienced group of MIC quality”, many managers paying too much for investments in high risk, early stage companies. investee companies The shake out came with the stock market crash of 1987 and the accompanying were among the demise of the Second Board Stock Exchanges around Australia. casualties. Over the In the “flight to quality”, many investee companies were among the next few years as their casualties. Over the next few years as their portfolios collapsed, many of the MICs portfolios collapsed, also succumbed. many of the MICs also The late 1980s and early 1990s can be characterised as a period when succumbed. entrepreneurship was a dirty word, technology was held in high suspicion, venture capital was “too hard”, and investors in private equity were few and far between. Australian Listed But good things did emerge from this period. Private equity Venture Capital Funds managers retreated into relatively safer, later stage investing, which Advent became known as “development capital”. Development capital or Australia Innovation expansion stage capital as it is more often called, remains a key Bio Tech Capital strength and pillar of the Australian private equity industry. Citadel Pooled Development Given their rocky experiences during the 1980s, the institutional ECAT Development Capital and retail investors had the money taps firmly turned off, and the eFinancial Capital government was extremely reluctant to have a second go at E-Shares stimulating the growth of the industry. First Wine Fund Although entrepreneurs and would-be private equity managers HG Ventures complained long and hard about the shortage of venture capital, all IT Capital they got was an endless series of Government reports telling them Jam Development Capital what they already knew – that there was a shortage of professional Lion Selection Group private equity, and particularly early stage venture capital. Local Telecom & Internet Loftus Pooled Development A New Growth Phase Medica Holdings Senetas THE year 1992 was good for the industry, with three developments SME Growth that were to contribute to a new growth phase that has continued unbroken since then. Starpharma Pooled Development Information about the industry became more widely and Strategic Pooled Development systematically available through the launch of the Australian Venture Vital Capital Capital Journal, private equity fund managers formed the Australian Wine Investment Fund Venture Capital Association to promote private equity as a new asset Source: Australian Venture Capital Journal class for institutional investors, and the Federal Government launched
  9. 9. rivate equity 8/11/01 10:31 AM Page 9 Colonial First State Investments the Pooled Development Funds (PDF) Program to provide 2 down - new equity capital for small to medium sized businesses and to form a new pool of private equity managers. The Pooled Development Funds Program THE PDF program was slow to get moving and for many years failed to win the support of superannuation funds and 18 to go … institutions, as had been hoped. The early support came from the retail market with some Colonial First State congratulates Integration Management Pty Limited and Endeavour HealthCare Limited on their recent of the early PDFs listing on the stock market, and from successful private equity placement. groups of wealthy private investors who co-invested into The new Colonial First State Diversified Private Equity Fund aims to invest in a diversified portfolio of unlisted companies PDFs that were structured as private investment companies. with the potential for high growth and higher returns than tra- Following several Government fine tunings, the PDF ditional sharemarket investments. And we are pleased to announce that the first two investments have now been made. Program has in recent years turned into a quiet achiever. PDFs are the vehicle of choice for many first time fund managers to the industry, they undertake a respectable proportion of the industry’s investment activity, and they underpin the retail market by being the largest group of Integration Management Pty Limited (IM) listed private equity vehicles. The fund has committed $4 million to IM, who has developed The success of the PDF Program is built on the Gov- billing software that allows telecommunications carriers to accurately invoice and verify the charges for the use of their ernment’s MIC Program experience, where it is generally own networks, as well as other carriers networks. We believe agreed that it was a mistake to have the tax deduction up this is not just a ‘nice-to-have’ but a ‘need-to-have’ product, making it an exciting investment opportunity. front in the year of investment. PDFs have the main capital gains tax concessions available at the end of the investment cycle when individual investments are sold. This means that investors now invest for capital gain and not the tax deduction. As of June 30, 2000, 57 PDFs had raised total Endeavour HealthCare Limited (Endeavour) The fund has also committed $7 million to invest in Endeavour capital of $476 million and had invested in 286 companies. HealthCare Limited. Aiming to provide a higher quality and more convenient service to patients, Endeavour is well-posi- tioned to become one of Australia’s leading integrated health- Fund-of-Funds care services providers. Share in the experience THE first private equity fund-of-funds was launched in 1995 Colonial First State is in the process of building a portfolio of when the Development Australia Fund re-organized itself potentially more than 20 companies. IM and Endeavour are but the first of these companies. Your clients now have an into an investable structure. Fund-of-funds are vehicles that opportunity to share in that growth. invest in a portfolio of managed private equity funds, For more information, talk to your Business Development reducing investor risk through diversification by managers, Manager, call our Adviser Service Centre on 13 18 36, business stage, industry sectors, and geography. or download a prospectus from www.colonialfirst- Fund-of-funds won early support from superannuation funds and institutions by allowing them to get a diversified But don’t leave it too long, as the fund closes on portfolio for a smaller capital commitment. More recent 31 July 2001. fund-of-funds have also been open to the retail investor by Please read the important information about Colonial First targeting their self-managed super funds. State and the Colonial First State Diversified Private Equity The first Australian-based international fund-of-funds Fund on page 4. were launched in 2000. To date all fund-of-funds have been unlisted vehicles.
  10. 10. rivate equity 8/11/01 10:31 AM Page 10 PRIVATE EQUITY Management Buyout Funds MBO vehicles are an THE late 1990s saw a big increase in the number of specialist management buyout attractive entry point (MBO) managers and vehicles, to the point where this sector of the private equity for first time market now commands available capital of several billion dollars and more if required. institutional investors MBO vehicles are an attractive entry point for first time institutional investors in private equity in private equity, as MBOs are later stage investments into established companies and so are seen to have a lower risk profile and more consistent returns. Because of the large amounts of capital involved, all current specialised MBO funds are unlisted wholesale vehicles, although some managers are looking at how they can tap the self managed superannuation fund market. Innovation Investment Funds Program The IIF Program aimed FOR many years the most undeveloped and difficult segments of the market were to provide capital for the early stage and technology sectors, as start-ups and technology companies small, early stage are well known as the most difficult to bring to commercial success. technology companies The drought finally began to break with the Federal Government’s Innovation while also encouraging Investment Funds (IIF) Program in 1997. This Program aimed to provide capital a new pool of venture for small, early stage technology companies while also encouraging a new pool capital fund managers. of venture capital fund managers. Government capital of $135 million was used to leverage another $65 million of institutional and private capital, and allocated to five managers. Early success led to a second IIF round in 2000 when an additional $90 million of Government capital was allocated to another four managers, who also raised new private capital. Technology Boom and Bust Capital managed THE IIF Program timed perfectly with the world technology boom of the late by the private equity 1990s, and helped draw an unprecedented number of new early stage industry began to flow technology companies into Australian private equity. dramatically into Capital managed by the private equity industry began to flow dramatically Australian technology into Australian technology for the first time since the MIC days in the mid-1980s. for the first time since The world technology boom was a glorious time for many venture capitalists and the MIC days in the their investors, with many stellar exits and record returns. mid-1980s. Fortunately, in the 15 months since bust followed boom on world stock markets, technology has continued to grow as a proportion of the Australian private equity industry’s total investment activity. This is not least because the casualty rate so far for investments among the venture capital managers has been far less than for retail and institutional investors on the stock market. Unlisted retail funds APART from some very early examples such as Hambro-Grantham Capital in the 1980s, and an odd pooled development fund in the mid-1990s, there was
  11. 11. rivate equity 8/11/01 10:31 AM Page 11 PAGE 11 virtually no movement in unlisted retail vehicles until the late 1990s. Since 1999 The number of there has been a sudden increase with the Advent III Private Equity Fund, unlisted retail funds BluePeak Venture Capital Technology Fund, JB Were Private Equity Fund, should continue to Macquarie Investment Trust III, and more recently Colonial First State grow as there are Diversified Private Equity Fund. This list should continue to grow as there are fundamental fundamental differences between listed and unlisted retail funds that suit differences between different investors. listed and unlisted The essential trade off is between liquidity and true value. Listed funds are retail funds that suit more liquid but usually trade at a discount to net asset backing. They are also different investors. subject to the whims of the stock market. Unlisted funds are highly illiquid, but the returns are based more accurately on underlying value and manager and investee performance. Recent Trends ANOTHER trend that picked up speed in the late 1990s and still continues is the New private entrance into the Australian private equity market of many of the world’s companies investing largest financial institutions – among them GE Equity, Deutsche Bank, ABN in a venture capital AMRO, UBS Capital and JP Morgan, which operate some of the largest private style continue to be equity operations in the world. drawn to the industry In 2000 the Federal Government launched its $76 million Building on Infor- as their founders, mation Technology Strengths (BITS) Program under which 10 technology usually high net worth incubators were financed to invest in seed and start-up stage information and individuals, seek to communications technology companies. move from being New private companies investing in a venture capital style continue to be business angel style drawn to the industry as their founders, usually high net worth individuals, investors to something seek to move from being business angel style investors to something more more formal. formal. The greater number of players and vehicles is driving the trend to ever greater specialisation. Whereas the early managers were mostly diversified investors, the industry now has a large and growing pool of specialists by industry, business stage and region. The State of Play THE growth of the Australian private equity sector can be seen in the statistics. For the first time, in From a virtual zero base in 1984, the industry had grown to an estimated 2000, the Australian capital base of $794 million by 1991 when the MIC Program closed. The latest and New Zealand data from the Australian Venture Capital Journal shows that in December 2000 industries together the Australian industry had total capital of $7.4 billion and investments in well invested over $1 billion, over 1,100 portfolio companies. and this level of activity For the first time, in 2000, the Australian and New Zealand industries has been maintained together invested over $1 billion, and this level of activity has been maintained into 2001. into 2001. Although the industry has room to grow for many more years, now is a very positive time, particularly for investors who have more choice than ever, and can be certain they will get more. s
  12. 12. rivate equity 8/11/01 10:31 AM Page 12 Colonial First State Investments advertorial Going public with Private Equity. The experience available through Colonial First State’s Diversified Private Equity Fund gives it the edge in this burgeoning area of investment. But investors need to act soon – the fund closes on Tuesday 31 July 2001. Most people think of private equity and venture ments did not meet that criteria,” he says. “Now, capital as high-risk, high-return investments following the shakeout in the market, we’re see- only available to the big end of town. But now, ing real businesses at realistic prices coming your clients can also invest in this emerging through the door.” class of assets, through Colonial First State’s The Executive Director of the Australian new Diversified Private Equity Fund. Venture Capital Association, Andrew Green, Steve Baldwin, Head of Colonial First State says private equity should be part of any mature Private Equity, says it’s a great time for investors portfolio. “For sophisticated investors, having to take advantage of the opportunity to invest exposure to a range of asset classes is the best in unlisted, or ‘private’, Australian companies. way to maximise your investment”. “A year ago, during the technology boom, Private equity represents less than two per we were seeing cent of the total pool of money available for prospective com- investment in Australia, but it’s growing strong- panies at overin- ly. The local private equity sector expanded sig- flated valua- nificantly last year to $8.5 billion1. tions. Being an Internationally, in places like the US and Europe, active manag- about 5% of available funds go to private equity. er, we believe Steve Baldwin says investors in the Colonial in buying First State Diversified Private Equity Fund will good assets at have an indirect interest in potentially more sensible than 20 businesses by the time the fund is fully prices and we constructed. “About a third of the money will felt these go to ‘early-stage companies’ and two-thirds invest- to ‘later-stage companies’,” he says. Go with experience One of the biggest attractions for your clients will be the the experience of the fund’s invest- ment manager, one of the most experienced private equity firms in Australia. “We have operated since 1984 (formerly as Hambro- Grantham Limited), and as the manager Steve Baldwin
  13. 13. rivate equity 8/11/01 10:31 AM Page 13 Key features: s Minimum commitment for individual investors — $30,000 in four equal instalments s Initial investment — 25% of your total commitment s Balance — to be paid over three years in three equal instalments s Investment term — 10 years s Investments — early stage (no more than 40% of the fund’s committed cap- ital), and later stage (at least 60% of the fund’s committed capital) invest- ments, with a preference for growth sectors The offer closes at 3.00pm on Tuesday 31 July 2001 (or earlier if over subscribed). of several private equity companies and funds, we’ve already invested in 70 businesses and van Eyk Research gives Colonial First State exited from over 50 of these,” he says. “We’ve Diversified Private Equity Fund a positive been through the full cycle of investing, sitting assessment: on the board and adding value, then exiting the s van Eyk concluded that the fund business and returning any net proceeds to offers an “…opportunity to investors investors.” to get exposure to a well diversified That’s a strong history in the relatively young portfolio of unlisted investments” Australian private equity sector. s van Eyk goes on to say, “Our assess- Baldwin cautions that private equity should ment of the CFS team’s skill set and constitute just a small part of your clients’ port- their deal flow generation, the two major factors driving the performance folios — between 5% and 10%. “It’s the pointy of private equity funds is positive” end of town in terms of risk-return: s “The Manager’s strategy is well for- high return, high risk,” he says. mulated with a strong emphasis If you’d like more information about the on risk management…” Colonial First State Diversified Private Equity s “Due to its favourable diversification Fund, please talk to your Business Development benefits and the potential for higher Manager, call our Adviser Service Centre on returns private equity has a place in most portfolios in varying degrees…” 13 18 36, or download a prospectus from Timeline of the Colonial First State Diversified Private Equity Fund 1 2 3 4 5 6 7 8 9 10 Fund Terminated Search for Opportunities and Invest (Years 1-3) Manage for Value/Growth (Years 2-7) Exit from Investments and Return to Investors (Years 5-10) Please read the important information about Colonial First State and the Colonial First State Diversified Private Equity Fund on page 4. 1 Australian Venture Capital Journal/Price Waterhouse Coopers Survey
  14. 14. rivate equity 8/11/01 10:31 AM Page 14 PRIVATE EQUITY By Greg Bright Diversification driving investors into largest ever retail offering THE head of private equity for Colonial First State Investments, Steve Baldwin, believes individual investors are keen to diversify their portfolios and this is driving their interest in the emerging asset class of private equity. Just a few weeks before his latest fund is set to close - possibly the largest ever raising for private equity from the retail market - Baldwin says investors are indicating they are comfortable with about 5 per cent of their total investments in private equity. “Some are saying more, up to 10 per cent, but 5 per cent seems to be the common number. Obviously, it fits neatly into a self-managed super fund.” The Colonial First State Diversified Private Equity Fund is seeking to raise $150 million, with a maximum of $250 million, through a prospectus offering with several unique features: s Colonial First State will provide some liquidity after four years through a partial buy-back option. s The investments will be diversified across industry sectors and stages of the business cycle. s All investments will be separately reviewed by an Investment Steve Baldwin it’s a great time to be investing Advisory Council of experts from different industries. s The manager’s private equity team will tap into the deal flow offered by its parent, the Commonwealth Bank. s The fund has been seeded with $40 million from the manager. While the prospectus, designed as a 10-year holding, says all the investments Colonial First State will be taken within four years, Baldwin is planning to be fully committed within Investments would three years. “It’s a great time to be investing because the sharemarket’s flat ... I’m typically examine very comfortable we’ll have the deal flow. We have a strong history and now we 400-500 deals a year, have the additional deal flow from the bank,” he says. and make only Colonial First State’s private equity division was formed following the five or six investments purchase in December last year of the former Hambros-Grantham business, from them. which had made 70 investments over 17 years, with over 50 exits to date. The firm would typically examine 400-500 deals a year, and make only five or six investments from them. Baldwin says this “hit rate” of about 1-2 per cent is fairly standard for the private equity market, however he is looking to improve on this at Colonial First State by getting pre-qualified leads from the bank. The new fund will make about 20 investments, with the first two already announced and a third likely before the prospectus closes on July 31. The fund has invested $4 million in Integration Management, which is a software developer and supplier for telecommunications billings, and $7 million in Endeavour Healthcare, which is an integrated healthcare company which is acquiring general medical practices as well as occupational health, radiology and pathology businesses.
  15. 15. rivate equity 8/11/01 10:31 AM Page 15 PAGE 15 THE new interest in private equity by retail investors has been helped along by last year’s changes to Capital Gains Taxation, which meant that the effective tax rate for investments held for more than 12 months, with a 50 per cent deduction, is 24 per cent for investors in the top tax bracket. Baldwin points out that in Australia, the private equity market is not as dependent on the sharemarket for exits as it is in the US. More than half the exits are achieved through trade sales in Australia and the rest through sharemarket listing, whereas the NASDAQ market accounts for most of the US private equity exits. Private equity does, however, compete with the sharemarket for purchases, especially during cycles when small-cap companies are running for the listed market. One such cycle was in the run-up to the tech wreck in March 2000, when small-cap listings, particularly Internet-related stocks, were hot. Baldwin says his team did not make one investment between July 1999 and March 2000 because the sharemarket was simply paying too much. “Companies which should have been private equity funded were being funded by the public markets. Then it corrected and companies have been coming back to the private equity market.” Private equity is not about very small companies, though. Colonial First Private equity funds State will be making an average investment of around $10 million through the do not correlate highly fund, taking only minority positions in each company. with the returns from The risks are, however, higher than for the broader listed market. Baldwin listed markets, which says the companies are younger and therefore may not have been through gives them extra several economic cycles. Their management teams are often smaller and appeal in a diversified sometimes stretched for resources. He also believes that these companies often portfolio. face greater competition because they do not often dominate their market segments. The analysis process prior to an investment is therefore rigorous and time consuming. Colonial First State has a team of eight investment directors and analysts with a combined 35 years private equity experience. Brian McGlynn joined the team as an investment director in March after being with Commonwealth Bank for 12 years, most recently as the chief engineer. He is responsible for instituting the process with the bank to pre- qualify leads for investment deals. Traditionally, private equity funds do not correlate highly with the returns from listed markets, which gives them extra appeal in a diversified portfolio. However, Baldwin says this fact may be over-emphasised by the “hidden” volatility in private equity investments. Like direct property, private equity investments will usually be valued no more frequently than every six months or year, disguising the ups and downs in between. But the diversification is very real through the nature of the investments. There are also some growth industries which are under-represented in the Australian listed market compared to overseas. s
  16. 16. rivate equity 8/11/01 10:31 AM Page 16 PRIVATE EQUITY By Greg Bright How a touch of private equity enhances a balanced portfolio THE key factor behind the inclusion of at least some private equity investments in a portfolio is that this will increase the “efficiency” of the portfolio. This means that portfolios will generate more returns per unit of risk if private equity is included. The adjacent chart showing the risk/return spectrum illustrates what common sense dictates: that venture capital and the broader category of private equity will generally offer higher returns, but with a higher level of risk as measured by volatility. The other chart, showing two efficient frontiers, illustrates that the inclusion of private equity moves the risk/return curve for a standard balanced portfolio up and to the left – the direction Risk/Return Spectrum: Private Equity and Venture Capital all investors should seek. vs Traditional Asset Classes 30.00 The charts are from a research paper by Venture Capital van Eyk Research, which assumed a 20 per 25.00 cent allocation to private equity, with a Private Equity 20.00 MSCI conservative annual return rate of 17 per RETURN (%) cent for the efficient frontier graph. For 15.00 the risk/return spectrum graph, van Eyk AFIX All Ords IFIX 10.00 assumes a 20 per cent return and 20 per Cash cent volatility for private equity and a 25 5.00 per cent return and 25 per cent volatility for venture capital. 0.00 0.00 5.00 10.00 15.00 20.00 25.00 The paper, commissioned by Colonial RISK (%) First State, says that due to the low market Source: Efficient Frontier – Private Equity Balance van Eyk Research 11 10.5 10 RETURN 9.5 9 8.5 Private Equity Included Base Scenario 8 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 RISK risk of private equity, it follows that the correlation between these investments and other asset classes over the long term will tend to be low. “Depending on the risk profile of an investor, we would suggest up to 10 per cent allocation in private equity investments within the overall portfolio, preferably spread across a few managers,” the paper says.
  17. 17. rivate equity 8/11/01 10:31 AM Page 17 PAGE 17 VAN Eyk is recommending an allocation of up to 5 per cent for investors deciding The researchers to go into the Colonial First State fund, at the same time warning that the bulk say the volatility of the return from the investment will occur between five and 10 years out. of returns from “Therefore, investors should be in a position where income from the investment, private equity has especially in the first few years, is not important,” the paper says. fallen over the last van Eyk says that an important characteristic of private equity returns is that five years, while the they are not uniformly realised across investments. “According to US statistics, 50 returns themselves per cent of all the gains from private equity investments come from about 10 per have risen. cent of the investments. “In other words, about one in 10 investments is respon- sible for half of all gains. Thus, diversification across investments in private equi- ty funds is extremely important.” The researchers say the volatility of returns from private equity has fallen over the last five years, while the returns themselves have risen. This can probably be attributed to a more sophisticated approach to assessing deals and to a greater level of diversification within private equity portfolios. The strongly rising sharemarket in the 1990s has played an important role, too, as private equity investors need strong markets to harvest the returns, van Eyk says. However this is less the case in Australia, where trade sales make up a much higher proportion of exits. s Colonial First State Investments A new asset class for DIY super funds. As you and your DIY clients know, DIY super equity in Australia in the year to funds can offer a great deal of flexibility. Your 30 June 2000? clients can invest in a broad range of asset classes, The Colonial First State Diversified Private like managed funds, direct shares and property. Equity Fund is an investment perfectly suited But they may not have considered alternative for people managing their own super fund – par- asset classes like private equity. ticularly if they want to diversify their portfolio Although it’s a relatively new asset class, pri- outside of traditional investments. vate equity is increasing its profile. Did you know The Fund’s 10-year timeframe also makes it suitable that more than $1 billion^ was invested in private for people with a long-term investment horizon. Don’t delay – it’s a limited offer closing on 31 July 2001 (or earlier if over subscribed). For more information about how the Colonial First State Diversified Private Equity Fund might fit into your clients’ DIY super fund, talk to your Business Development Manager, call our Adviser Service Centre on 13 18 36 or explore Please read the important information about Colonial First State and the Colonial First State Diversified Private Equity Fund on page 4. ^Source: Australian Venture Capital Association Limited (AVCAL) 2000 Yearbook
  18. 18. rivate equity 8/11/01 10:31 AM Page 18 PRIVATE EQUITY By Martin Lawrence Planners’ private equity options widen Now retail investors are IN the past two years, the retail private equity market has started to flourish, being offered the with more and more providers launching funds. The old model for retail private equity was listed trusts. But given the fate of Challenger’s bioscience funds which institutional model of listed last year and are now trading below their issue price despite reasonable private equity, where performance, the future for this type of vehicle is uncertain. Now retail investors investors go into closed are being offered the institutional model of private equity, where investors go end unit trusts with a 10 into closed end unit trusts with a 10 year horizon, with no exit possible before year horizon, with no the fund is wound-up. exit possible before the General manager of bluepeak (the alternative investments division of Challenger), Hugh Latimer, says its model for private equity, as well as other fund is wound-up. alternative asset sectors like hedge funds, is to give greater access to retail investors. ”We’re looking to provide the institutional opportunities to the retail investor,“ he says. Since 1999, Macquarie, Ord Minnett (which sold bluepeak to Challenger last year), JB Were, and Continental Venture Capital (CVC) have made direct pitches to the retail market. Colonial First State, new private equity firm Crescent Capital Partners and CVC are also now raising new retail funds. Although money is starting to flow into the sector from retail investors, it is still a very small percentage of the overall total. Venture Economics estimates about 1 per cent of the capital committed to private equity at June, 2000 came from retail investors. The retail market’s THE retail market’s appetite for private equity seems unaffected by the broad appetite for private market downturn in the last half of 2000. equity seems Head of private equity at JB Were Investment Management, Bernard Stanton, unaffected by the says it was able to raise $146 million in the year up to September 2000, even broad market though ”at the time the market was pretty flat.“ And in a poisonous downturn in the last environment for technology investing, bluepeak, (then at Ord Minnett) was able half of 2000. to raise $25 million for a venture capital technology fund, managed by technology specialists Allen & Buckeridge. ”Had we launched it prior to the tech wreck we probably would have raised a huge amount of money,“ says Latimer, who moved over to Challenger with bluepeak. ”But we keep stressing it’s a 10 year opportunity, not a 10 day wonder.“ There are two models for direct retail private equity investing. The first, used by Macquarie and bluepeak, is to raise money from the retail market and then patch it into an institutional trust. Macquarie’s first retail offering, the Macquarie Private Equity Trust, raised $90 million from retail investors in 1999 which was then fed into a wholesale trust managed by the Macquarie Direct Investments team. This model has been used for subsequent raisings by Macquarie, including its retail fund-of-funds, the Private Equity Multi-fund. Challenger’s bluepeak offering flows into Allen & Buckeridge’s $125 million wholesale fund. Also raising a mixed fund is new player Crescent Capital, which is a venture capital manager seeking $11 million from retail investors to complement $25 million in institutional money.
  19. 19. rivate equity 8/11/01 10:31 AM Page 19 PAGE 19 PURE retail funds are the other model, used by JB Were and CVC. JB Were’s fund, aimed at the expansion capital end of the market, was raised from 3000 investors and is the biggest retail private equity fund raising in Australia to date. This fund has already made three investments with another two close to being finalised, according to Stanton, with a target of between 10 and 15 investments. ”You can’t have too many investments because a lot of the value’s added by having one of our team on the board,“ he says. Stanton says his team has seen between around 700 potential deals since the fund closed in September, proof of the strength of the Australian private equity market. CVC is about to start raising its second and third retail funds, both of which will have an expansion capital focus. One is the Eco Fund, which is raising about $25 million to invest in small Susan Gosling Fund director, Eco Fund companies promising strong environmental performance or potential to improve the environment, in addition to financial success. According to fund director, Susan Gosling, it will invest in environmental innovators with potential to list on the stock exchange in three to five years. The small target fund size is deliberate, says Gosling, designed to improve CVC’s ability to focus on only the best companies as well as be actively involved with its portfolio. ”We often have to manufacture deals by putting small companies together,“ she says. LIQUIDITY is a vexed issue for private equity investors, but most retail private Although Macquarie equity funds in Australia do try to reduce the inherent illiquidity of the asset has marketed private class. All the available retail funds immediately return earnings from investments equity as an to unit holders. investment where Some funds, such as Macquarie’s Private Equity Trust, have already returned early returns should money to investors due to unexpectedly early exits from some deals. Associate not be expected, this is director with Macquarie’s Financial Services Group, Chris Bowen, says although not necessarily the Macquarie has marketed private equity as an investment where early returns case. should not be expected, this was not necessarily the case. ”We market it as a 10 year investment and you’ve got to be prepared to commit for 10 years,“ she says. ”But we were actually distributing to investors at about the same time we made our second funding call.“ It’s important to note that no private equity manager would guarantee returns to investors within two years of the beginning of a fund, but the illiquidity of the asset class is sometimes over-stated. Many private equity managers do not take all of an investor’s commitment up-front, with managers like JB Were and Macquarie instead making two or three funding calls over the first two years of the fund. CVC’s Gosling says for the Eco Trust, the manager was contemplating an up- front investment held in a cash management trust until invested, because planners had found administration of further cash calls difficult. ”Many planners didn’t like the staggered draw-downs,“ she says, adding CVC may consider an option scheme, where an investor will be given the choice to commit more after their initial investment. s
  20. 20. rivate equity 8/11/01 10:31 AM Page 20 PRIVATE EQUITY By Martin Lawrence Negative and positive examples set by US industry NO investment sector is complete without its horror stories. The problems experienced in equities by managers like BT over the past two years, or the difficulties experienced by County Investment Management in its enhanced cash funds, show well-known, publicly traded assets can prove risky. But in the US private equity market, especially at the venture capital end, the past year has been a litany of horror stories. Managing partner with private equity fund-of-funds, Quay Partners, Sam Armstrong, says US venture capitalists got carried away by the technology boom in the same way the public markets did. “What was happening was that people believed the rate of innovation and productivity gains through technology meant there had been a change in the nature of the economy,” Armstrong says. “All we saw was a good old- fashioned market bubble.” Private equity managers live and breathe on the quality of deals they can get access to and on their ability to pick good investments by conducting due diligence. Armstrong’s partner, Stephen White, tells the story that he asked an experienced US venture capitalist at the end of 1999 what kind of due diligence procedure they had in place. Sam Armstrong The answer, as White relates it, spoke volumes for what happened in the US: Managing Partner, “Due diligence? I don’t have time to do due diligence.” Other stories were Quay Partners circulating of venture capital managers funding a company and then listing it on the Nasdaq after 90 days, an unbelievable turnaround for early-stage investments usually held for up to five years. COLONIAL First State Investments’ head of private equity, Steve Baldwin, attributes part of the problems with the US to the country’s private equity model. Unlike in Australia, where the most common exit method for private equity investments is by a sale to another company, IPOs are much more common in the US. Baldwin estimates about 90 per cent of exits in the US are through a listing and this means when the Nasdaq took off, private equity managers could not resist trying to cash in on the remarkable returns. One of the US’ leading venture capitalists, managing partner of Crosspoint Venture Partners, Rich Shapero, claimed in November 2000 about 80 per cent of private equity managers were struggling with consumer internet companies in their portfolios. Even more worrying for US investors, Shapero went on to claim some VCs had 30 to 40 per cent of their portfolios in failed business-to-consumer models.
  21. 21. rivate equity 8/11/01 10:31 AM Page 21 PAGE 21 JB Were Asset Management’s head of private equity, Bernard Stanton sees “Our guys didn’t go clear differences between the Australian industry and that in the US. “Here we over the top,” Green still have a lot of discipline,” he says. “If anything the entrepreneurs get a bit says, which he frustrated because we do our homework.” Andrew Green, executive director of attributes to the the Australian Venture Capital Association, echoes Stanton’s comments. “Our guys relative youth of the didn’t go over the top,” Green says, which he attributes to the relative youth of Australian industry. the Australian industry. “If you’ve only got a small amount of capital you’ve got to be very careful with your investment.” HOWEVER the problems in the US private equity shouldn’t be overstated. Certainly, US institutional appetite for private equity in all forms remains high. The world’s second largest pension fund, the California Public Employee’s Retirement System (CalPERS), has allocated $US 14 billion to private equity on the back of stellar returns from its private market portfolio. For the year to June 30, 2000, CalPERS’ private equity portfolio was its most lucrative investment, returning 58 per cent. Matrix Partners, one of the best private equity firms in the US, had an estimated annual return during the 1990s of 95 per cent, compared to Venture Economics’ US private equity 30 year average annual return of 28.6 per cent. Quay Partners’ Armstrong says recent activity in the US private equity market has been at the later stage of the market, as managers and investors react to the excesses of the past two years. The fall off in venture capital-backed IPOs in the US has been dramatic. According to figures from Reuters’ VC research firm, VentureOne, there were 70 venture capital-backed IPOs in the US in the first quarter of 2000, compared to just five in the first quarter of 2001. MONEY is continuing to flow into the US private equity market, where individual Many big US investors have a much greater (if still modest) presence when compared to institutions, especially Australia. Many big US institutions, especially the charitable trusts and university the charitable trusts endowment funds, have allocations as high as 20 per cent to private equity. This and university partly explains the huge amounts of capital available for investment in the US endowment funds, market – in the first quarter of 2001, according to Venture Economics, about $23 have allocations as billion was invested in private equity. By comparison, in Australia the entire year high as 20 per cent to 2000 saw $831 million invested – and it should be remembered, the first quarter private equity. of 2001 saw the least investment in US private equity since the end of 1998. Armstrong says one of the reasons the US market is so mature is because the US Government has been actively involved in encouraging private equity investment for over 50 years. By comparison, the Australian government has only been actively involved in encouraging private equity for a little over a decade. The difference to the economy of the two countries, and the potential for growth and high returns from the young Australian industry, is illustrated by figures from the US National Venture Capital Association (NVCA). A study done by research firm, WEFA, for the NVCA, found companies which had been backed by private equity created 4.3 million jobs in 2000 and generated $US 736 billion in revenue. WEFA researcher Andrew Hodge says there are 11 companies in the US today which have sales of over $US 10 billion annually which were backed by private equity in the 1970s and 1980s, including glamour names like Intel and Compaq. s
  22. 22. rivate equity 8/11/01 10:31 AM Page 22 PRIVATE EQUITY By Craig Phillips Pre-venture capital – where incubators and angels like to tread A GOOD idea has a hard road to travel from origination to buy-out or public listing. Not even venture capital firms are always there at the beginning, particularly in Australia where the private equity focus is on more mature companies than in the US. Traditionally, it is ‘incubators’ (government-assisted initiatives to nurture new business) or ‘angels’ (private investors in a project) which fill the gap between the early stages of a business’ life and the period when venture capitalists enter the fray. “The role of an incubator is to shepherd and grow these very early stage businesses and make them investment-ready for the down-stream investors,” says managing director of technology incubator ITem3, Rob Forage. ITem3 was given a $3.7 million grant under the Federal Government’s Building On IT Strengths (BITS) program in June 2000. It has been in existence for 12 months, and within the first 9 months had made 60 investments in start-up companies, focussing on technology. Entry depends on good deals, and good deals depend on an incubator’s or venture capitalist’s awareness of promising initiatives. Subsequently, the whole venture capital industry is highly reliant on a developed network of contacts, both Michael Alscher formal and informal, which are essential for identifying potential clients and Executive director, Crescent Capital Partners providing deal flow – the lifeblood of venture capitalists – according to Crescent Capital Partners executive director Michael Alscher. Alscher’s sentiment is echoed at VC firm Allen & Buckeridge (A&B). “As well as people who send us business plans... Entry depends on existing investors tend to provide good recommendations of deals and we also rely good deals, and good heavily on our contacts,” says A&B general partner, Frank Foster. “We tend to deals depend on an invest when companies have a demonstrable technology [and] the stage when incubator’s or there has been customer acceptance of the technology,” Foster says. venture capitalist’s This tendency to invest later in businesses is logical, given the fallout of the tech awareness of crash last year, however ITem3’s Forage believes it is part of a broader Australian promising initiatives. VC industry culture. “The US [VC] industry tends to focus on the early stage entrepreneurial idea, Europe tends to focus on the merger and acquisition phase...Australia tends to focus on companies which are more mature,” Forage says. However A&B’s Foster believes later entrance into the market is wasteful, and it denies some initia- tives reaching full potential. “[Given] Australia spends $8.8 to $9 billion a year on research and development, whereas it only invests $100 to $300 million in the commercialisation of the research and development, the general feeling from all the top Frank Foster General partner, firms is that more deals go unfunded Allen & Buckeridge than there should,” he says. s
  23. 23. rivate equity 8/11/01 10:31 AM Page 23 Colonial First State Investments The Fund is almost over. Fund closes 31 July 2001. The Colonial First State Diversified Private Equity Fund Please read the important information about Colonial First State and the Colonial First State Diversified Private Equity Fund on page 4.
  24. 24. rivate equity 8/11/01 10:31 AM Page 24 Colonial First State Investments April 1995 Future Leaders Fund April 1997 Developing Companies Fund May 2001 Diversified Private Equity Fund How does the fund work? Networks The Colonial First State Diversified Colonial First State Private Equity’s Private Equity Fund will invest in expansive network of business companies at the ground level, well relationships also provide a before they are listed on the sharemarket. distinct competitive advantage. We take a seat on the company board, This network has been further develop management teams, generate enhanced by becoming part of the and refine competitive strategies, and wider Commonwealth Bank Group, help build their businesses. and provides access to competitive Colonial First State are in the process capital market information, as well of building a portfolio of around as strong sources of dealflow. 20 companies that we believe have This fund is likely to suit assertive the potential to deliver higher returns investors who are prepared to invest than traditional share investments. at least $30,000 for a minimum of Your clients have an opportunity to 10 years. We would be foolish to share in that growth. promise blockbuster returns, although in the last 10 years the returns for private Experience equity funds have averaged more than Colonial First State Private Equity 16% pa in Australia and more than 20% Limited (formerly Hambro-Grantham pa in the United States.^ Colonial First State has a reputation of Limited) is one of the most experienced being able to uncover small companies private equity firms in Australia. As For more information talk to your that have big potential, most notably the manager of several private equity Business Development Manager, through our Future Leaders and companies and funds, we have invested call 13 18 36 or explore Developing Companies funds. in 70 businesses and exited from over It seems only natural then, that 50 of these investments as at 31 March we should launch a new fund which 2001. We are unaware of any other But don’t leave it too long, the specialises in finding small unlisted private equity manager in Australia fund closes on 31 July 2001. companies, and assists them in today who has been through the full developing their business. cycle that many times. Please read the important information about Colonial First State and the Colonial First State Diversified Private Equity Fund on page 4. ^Source: Australian Venture Capital Association Limited (AVCAL) 2000 Yearbook.