How to invest in private equity


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How to invest in private equity

  1. 1. How to invest in private equity You should refer to your investment consultant for detailed, specific advice on private equity investment. What do I need for a successful private equity investment strategy? A long-term investment horizon. A suitable investment benchmark return when considering private equity investment. • To select the right method of private equity investment to suit your requirements (see "Methods of investing in private equity"). This usually entails engaging a specialist private equity manager. A spread of private equity investments to diversify the types and stages of the investee companies. How much should I commit? An investor is rarely required to invest its maximum commitment to a private equity fund, with funds typically drawing down from 80%-95% of commitments. Commonly, only a maximum of 60% of an investor's total commitment is outstanding at any one time. How is the cash I have committed actually drawn? Cash is usually drawn down on an investment by investment basis (generally in years one to five). Cash is returned to the investor as and when investments are realised (often from year three onwards). This can mean that within a four- to six-year period, you could receive back as much as you have committed to a fund. A fund investing in private equity is likely to take longer to repay commitment than one focused on buy-outs. How is my investment realised? Even though funds generally have a 10-12 year life, typically they begin to return cash to investors after three to five years. A mature portfolio of several private equity funds is usually highly cash generative. If one of the investments made by the private equity manager is realised through flotation, the investors in the fund are occasionally offered the shares in the newly quoted company. More usually, the shares are held within the fund until finally sold by the private equity manager. There is a small but growing secondary market in private equity funds. This offers investors a way of exiting from their entire private equity portfolio before it is wound up. However, secondary trades in private equity funds are often undertaken at a discount and investors should not rely on the secondary market. Details of secondary purchasers can be found in the BVCA's Directory of Members, under 'associate financial members' and on the BVCA's website. How do private equity managers raise funds? Private equity firms usually manage funds structured as limited partnerships and tend to raise a new fund every three to five years. A fund-raising can be spread over several months. When raising a fund, a private equity firm will produce a private placing memorandum. This document gives detailed information on: • the private equity firm; • the funds and the investments it previously and currently manages and their performances; • valuation of unrealised investment and valuation policy;
  2. 2. • the firm's executives and their relevant experience; • the fees chargeable and management incentives; • the fund's investment strategy; • reporting methods and details of how often reports will be published. This memorandum may be sent to institutions directly by the private equity firm or via intermediaries such as placing agents and investment consultants. How do I find out who is fund raising? See the BVCA's list of funds currently being raised on the BVCA's website under 'institutional investors'. Also on this website is the BVCA's searchable directory of private equity firms for contact details. Introduce yourself to private equity firms and get on their mailing lists. Details of firms that manage limited partnership funds can also be found on the BVCA's website under 'institutional investors'. Read the press. Some funds publicise their fund-raising activities through letting journalists know, but they are not permitted by law to advertise that they are raising a fund. A fortnightly publication called "...unquote" lists the details of most funds being raised (published by Initiative Europe on 01737-784 200). Speak to your investment advisers who are frequently contacted by private equity firms and placement agents.
  3. 3. Methods of investing in private equity How can I invest in private equity? Through private equity funds alongside other investors. These are typically structured as limited partnerships (fund route). Through a fund managed exclusively for your scheme by a private equity fund manager (segregated route). Through quoted venture and development capital investment trusts (investment trust route). Through a "fund of private equity funds" managed by a gatekeeper (fund of funds route). By making direct investments into unquoted companies (direct route). Fund route Pros Cons Over 200 private equity funds enabling a Need for staff or advisers to achieve and wide selection of investment maintain a good knowledge of private opportunities equity fund managers, fund raisings, Wide range and number of private portfolio content, performance, etc equity managers seeking to raise new Minimum level of investment may apply. funds in which to invest over the next few years High level of control Private equity funds are directly accountable to you Many private equity fund managers take a position on the board of the company in which they invest to keep in close contact with the company's development Established private equity funds have a high level of expertise and quality deal flow. Segregated route Pros Cons High level of control Requires very substantial funds to be commercially viable and to spread risk. Good accountability and direct contact Flexible - no fixed time period and can be tailored to your requirements, eg. commitment period. Investment trust route Pros Cons Share price reported on a daily basis Shares may trade at a discount to net asset value Liquidity Increases correlation of returns with Many investment trust managers take a quoted markets. position on the board of the company in which they invest to keep in close contact with the company's
  4. 4. development Established investment trusts have a high level of expertise and quality deal flow Relatively low fees and transaction cost. Fund of funds route Pros Cons Access to a diversified private equity Additional layer of fees (from the portfolio eliminating the risk of under- gatekeeper and the private equity fund diversification manager) Expertise in investing in private equity Potential barrier between investor and funds, knowledge of private equity underlying private equity managers, managers' performance, methods, reducing contact with, and portfolios, fund raising timings, etc understanding of, the private equity market Offers an insight into private equity fund investment for those who do not Slightly longer-term commitment (up to yet wish to be involved in in-house or 15 years). direct fund investment Minimises administration - e.g. only one set of calls and distributions to deal with. Direct route Pros Cons Full control Full responsibility Direct access to unquoted companies. Requires very substantial funds to achieve an adequate spread of investments Cost and commitment: need for substantial permanent specialist staff Staff need expertise in negotiating and structuring the initial investment, monitoring the companies and exits Requires access to potential investment opportunities, as success depends on quality and quantity of deal flow.
  5. 5. What key points should I consider when selecting a private equity manager? Managers of private equity limited partnership funds Performance record Ability to add value to portfolio companies (past, present and future) Deal sourcing ability (past, present and future) Process established Exit ability/experience Experience/commitment/motivation of key executives Investment strategy fits with your requirements Evidence of ability to move with changing market conditions to ensure future returns Flexibility - is the minimum/maximum investment permitted in line with your needs? Distribution policies - are distributions managed so that investors can obtain cash, thus eliminating the need for them to take on the task of managing distributions? Fees and terms Reporting methods Gatekeeper/fund of funds manager Performance record Proven ability to access the best private equity managers. The better private equity funds are often oversubscribed and access can be by invitation only Appropriate diversity across stage, style and geography Flexibility - is the minimum/maximum investment permitted in line with your needs? Distribution policies - are distributions managed so that investors can obtain cash, thus eliminating the need for them to take on the task of managing distributions? Fees and terms Reporting methods What fees are generally charged by a private equity manager? The annual management fee is usually based initially on the amount of capital committed to the fund. Management incentive fees, or carried interest, is usually payable as a proportion of investor profits after hurdle rates have been achieved. Fees levied by private equity managers are generally higher than for other asset classes. This is because the sourcing, purchasing, monitoring and realisation of private companies is more labour intensive per £1 invested. These higher fees are balanced by higher expected returns. The fees chargeable will be listed in the private placing memorandum. Private equity fund returns are generally quoted net of all types of fees, which is how returns are shown in the BVCA's annual Performance Measurement Survey.
  6. 6. London Business School's key recommendations to pension fund investors In January 2000, an independent report was undertaken by London Business School, commissioned by the BVCA and supported by the National Association of Pension Funds, which examines private equity as an asset class for pension fund investors. Some of the key recommendations made by the report follow. • Take a long-term perspective The decision to invest should be taken with a long-term perspective in mind since it normally takes three to five years before investors experience positive returns and net cash flows. • Be prepared to make higher nominal fund allocations Usually a maximum of 80% - 95% of an investor's committed capital is drawn down. Investors should be prepared to make higher nominal fund allocations to this asset class in order to achieve their target exposure. Commonly, only around 60% of an investor's total commitment is outstanding at any one time. • Appoint a dedicated private equity fund manager Managers of private equity portfolios should be subjected to different organisational procedures from the managers of marketable security portfolios. The assessment of track records and selection of private equity firms - skills that have a large impact on the returns of a private equity portfolio - require an expertise which is quite different from analysing public equity markets. London Business School suggests that pension funds appoint exclusive private equity managers and subject them to different incentive and monitoring procedures. • A well-structured portfolio A well-structured private equity portfolio has attractive cash flow implications. Initially it will require net contributions over several years. After this period, such a portfolio should generate positive net cash flows for a longer period. • Growth in the secondary market The growing secondary market has led to a substantial improvement in the liquidity of the private equity industry. • Diversify between funds and managers Diversification between funds and managers smooths cash flows and can reduce the spread of returns. (Details of private equity firms can be found on the BVCA's website at and in the BVCA Directory of Members.)
  7. 7. Frequently asked questions and answers What size is the industry? Over £60 billion has been invested by UK private equity firms in over 25,000 companies between 1984 and 2003. Over £67 billion has been raised by independent private equity funds from 1988 to 2003. Market capitalisation of venture and development capital investment trusts totalled £6 billion in September 2003. "Captive" private equity funds - those owned and only obtaining funds from their parent organisations (such as banks or insurance companies), accounted for 6% of 2003's total UK investment. How liquid is private equity investment in practice? Technically, investment trusts are unable to distribute realised gains, but in practice liquidity is gained through their quotation. As with all quoted shares, this is subject to general constraints on marketability, such as the size of the holding. Individual limited partnerships are unquoted, but are self liquidating and distribute realised gains and dividends to investors during the life of the fund. It may be noted that because these funds draw down capital in several tranches and make periodic distributions, commonly only a maximum of 60% of an investor's total commitment is outstanding at any one time. Typical private equity fund cash flow (Commitment = 100) Source: Westport Private Equity Limited Are private equity investment returns under downwards pressure? The size and number of some funds raised, particularly recently, have made press headlines. It is worth noting, however, that most of these are larger buy-out funds with a pan-European rather than purely UK focus. The continental European market is less mature than that in the UK. A well-structured fund, run by a good manager with strong pricing disciplines that prevents overpayment, should be able to maintain the higher levels of returns. Your adviser should know the investment policies of the private equity funds and their potential returns.
  8. 8. What sort of private equity funds are available for investment? See the section on "Methods of investing in private equity" which will give you some pointers. Different pension funds will have different requirements and resources. Should investment be in more than one fund? A portfolio of private equity fund investments may be advisable in order to give a spread, as with investment in any other asset class. This can be achieved either by investing in more than one fund or by investing in a fund of funds. Why invest in private equity? With suitable diversification, you can achieve long-term superior returns.
  9. 9. Appendix 1 - Private equity terms and definitions The term "private equity" is the term generally used in Europe to cover the industry as a whole, both buy-outs and venture capital. "Venture capital" is a subcategory covering the seed to expansion stages of investment. Private equity describes equity investments in unquoted companies often accompanied by the provision of loans and other capital bearing an equity type risk. Below are descriptions of the different stages of private equity investment. Types of private equity Buy-in management buy-out (BIMBO) Provision of equity capital to enable a company's management to acquire the business they manage with the assistance of some incoming management. Institutional buy-out (IBO) Provision of equity capital to enable a private equity firm to acquire a company, following which the incumbent and/or incoming management will subscribe for or otherwise acquire a stake in the business. Management buy-in (MBI) Funds provided to enable an external manager or group of managers to buy into a company. Management buy-out (MBO) Funds provided to enable current operating management and investors to acquire an existing product line or business. Public to private (PTP) The purchase of all of a listed company's quoted shares using a special purpose vehicle funded with a mixture of debt and unquoted equity. Refinancing bank debt To replace or reduce a company's level of gearing. Replacement capital Equity capital which allows existing equity investors to buy back, replace or redeem their shareholding. Rescue/turnaround To provide equity to finance a company in difficulties or to rescue it from receivership. Secondary purchase Purchase of existing shares in a company from another private equity firm. This is often done when a private equity manager wishes to sell his stake in a company to allow him to wind down a mature fund at the end of its life, or from another shareholder or shareholders. Venture capital • Seed Provision of equity capital to allow a business concept to be developed, perhaps involving the production of a business plan, prototypes and additional research, prior to bringing a product to market and commencing large-scale manufacturing. • Start-up Financing provided to companies for use in product development and to fund their initial marketing. Companies may be in the process of being set up or may have been trading for a short time, but may not have sold their product commercially. • Other early stage Provision of equity capital to initiate commercial manufacturing and sales in companies which have completed the product development stage, but may not yet be generating profits.
  10. 10. • Expansion Provision of equity capital to grow and expand an established company. For example, to finance increased production capacity, product development, marketing and to provide additional working capital. Also known as "development" or "growth" capital. Terms of private equity Carried interest or carry Equivalent to a performance fee, this represents the share of a private equity fund's profit that will accrue to the general partners (also see "Hurdle rate"). Committed funds or raised funds Capital committed by investors. Cash to the maximum of these commitments may be requested or drawndown by the private equity managers usually on a deal-by-deal basis. This amount is different from invested funds for three reasons. Firstly, most partnerships will initially invest only between 80% and 95% of committed funds. Second, it may be necessary in early years to deduct the annual management fee which is used to cover the cost of operation of a fund. Third, payback to investors usually begins before the final draw down of commitments has taken place. Distributions These are payments to investors after the realisations of investments made by partnership. Exits, divestments or realisations Private equity investors generally receive their principal returns via a capital gain on the sale or flotation of investments. Exit methods include a trade sale (most common), flotation on a stock exchange (common), a share repurchase by the company or its management or a refinancing of the business (least common). Secondary purchases of the company by another private equity firm are becoming an increasingly common phenomenon. Draw downs These are payments to the partnership by investors in order to finance investments. Funds are usually drawn down from investors on a deal-by-deal basis. Funds of funds These are funds whose principal activity consists of investing in private equity funds. Investors in funds of funds can thereby increase their levels of diversification. Gatekeepers These are specialist advisers who assist institutional investors in their allocation decisions to private equity. General partners These are the private equity firms, who select investments, structure deals, monitor investments and design the appropriate exit strategies on behalf of the limited partners. Hurdle rate This is the minimum return to investors to be achieved before a carry is permitted. A hurdle rate of 10% means that the private equity fund needs to achieve a return of at least 10% per annum before the profits are shared according to the carried interest arrangement. Interim return The final rate of return of a private equity investment can, by definition, only be calculated when all investments are sold and the fund is wound up. Most return calculations therefore produce interim IRRs which are close to the final rate of return after approximately three to six years. This convergence period is usually shorter for buy-out funds than for early stage and development funds. Internal rate of return (IRR) The IRR method is the most appropriate method for calculating the returns of a private equity fund. In essence, the IRR represents the rate at which positive and negative cash flows are discounted so that the net present value of the fund amounts to zero. It is not consistent with the time weighted
  11. 11. return (TWR) used for other components of a scheme's investment portfolio and care should be taken in making comparisons. Investment stage In this publication, the term investment stage refers to the fund's investment preferences. In accordance with the cut-offs used for the BVCA's annual Performance Measurement Survey, funds were divided into: • Early stage funds - investing in companies in the seed (concept), start-up (within three years of a company's establishment) and early stage of development; • Development funds - investing in expansion stage companies, for example, established companies which raise private equity to make acquisitions, fund working capital, buy new plant, etc. Also small management buy-outs (MBOs) and buy-ins (MBIs) with less than £10m of equity invested; • Mid MBO funds - investing in MBOs and MBIs with £10m-£100m of equity invested; • Large MBO funds - investment in MBOs and MBIs with more than £100m of equity invested; • Generalist funds - investing in companies at a variety of stages of development. Limited partnerships In limited partnerships, institutional investors generally constitute the limited partners and private equity firms act as general partners. The minimum investment considered by many private equity firms usually amounts to 1% of the total funds being raised. The maximum investment usually accepted from a single investor corresponds to about 10% of the total fund size. The majority of private equity funds include between 10 and 30 limited partners. A limited partnership usually has a life fixed initially at 10 years during which the general partners select investments, structure deals, monitor investments and design the appropriate exit strategies on behalf of the limited partners. The partnership's funds will usually be invested by the general partners within three to five years. Despite being set up with an initial life of 10 years, many funds continue to exist beyond that period because some investments will not be fully realised within the intended life of the fund. When all investments are fully divested, a limited partnership can be terminated or "wound up". Private equity funds Managed by private equity firms who raise funds from external sources, such as pension funds, insurance companies and others. There are over 200 such funds managed by BVCA members. For the pros and cons of investment - see the section on "Methods of investing in private equity". Secondary market The secondary market enables investors to buy and sell stakes in private equity funds whilst it is ongoing. Trade sale This is the sale of the equity share of an investee company to another company. Venture and development capital investment trusts Quoted private equity funds that invest "a significant portion of [their] ...portfolio in the securities of unquoted companies" (definition: Association of Investment Trusts). There are around 20 managed by BVCA members. For the pros and cons of investment - see the section on "Methods of investing in private equity".
  12. 12. Appendix 2 - The economic role of the UK private equity industry Funds invested by BVCA members £ millions Source: BVCA The UK private equity industry is the largest and most developed in Europe - accounting for 47% of total annual European private equity investment in 2003 - and is second only to the USA in world importance. The industry's impact on Europe is shown through the investments undertaken by BVCA members' UK offices into overseas companies. Not included, however, are those investments made by BVCA members' offices based overseas. These are growing rapidly as local contacts and networks are increasingly seen as important in developing an active international private equity business. For companies in which private equity investments are made, it marks the beginning of a relationship that generally will span three to seven years or more. Private equity firms not only commit funds, but also contribute their extensive experience, contacts and advice to companies in which they invest. This input was rated highly by private equity backed companies in recent research. The private equity industry has a crucial role to play in financing and helping create successful enterprises in the UK. In a major independent survey of the economic impact of private equity in the UK, it was demonstrated that over a four year period: • Private equity backed companies create more jobs Over the five years to 2003/4, private equity backed companies increased their staff levels at a rate of just over five times that of FTSE 100 companies and three times that of the companies in the FTSE 250. The number of people employed in private equity backed companies increased by 20% p.a., against a national growth rate of 0.6% p.a. It is estimated that companies that have received private equity account for the employment of around 2.7 million people, equivalent to 18% of the current private sector workforce. • Private equity backed companies boost the UK economy On average, over the five years to 2003/4, private equity backed companies increased their: - sales by 23% p.a., or twice as fast as FTSE 100 companies; - exports by 20% p.a., compared with a national growth rate of 3.3%; - investment by 5% p.a. compared with a national increase of 1.9%. • 81% of the companies could not have existed or would have grown less rapidly without private equity • Over three-quarters of the companies felt that the private equity firms had made a major contribution in addition to the provision of money. Other major contributions cited by private equity backed companies included private equity firms being used as a sounding board for ideas, challenging the status quo, for their financial advice, guidance on strategic matters and their contacts and market information.
  13. 13. The UK private equity industry is continuing to prove its resilience by anticipating and shaping economic developments. Whatever the industry's achievements, we are not complacent. The industry continues to evolve with new areas and methods of investment to ensure that returns to investors and management teams continue to be maximised. There is much evidence that the industry is continuing to expand its influence.