Staying afloat

Among the swathes of bad news coming out of the private equity sector at the moment, two ongoing stories have stood out for many. The plight of industry heavyweights 3i and Candover, both pioneers of the asset class in their own way, have provided much fodder for the broadsheets and trade press alike, and become regular topics of conversation at sombre industry meetings.

Seen by some as merely another cautionary tale coming out of the financial services space and something of a comeuppance for private equity specifically, within the industry the recent troubles at these brands has sparked a debate about the viability of the listed model. Much of the discussion has focused on the investment strategies seen to be employed by such vehicles, which has resulted in high gearing levels and difficulties in honouring commitments.

The fight to float

However, it is arguable that these two firms are not typical examples of listed private equity. In both cases it is not merely an investment trust that is listed but rather the whole business, encompassing both a fund and the management company. That their operations are closer to that of a traditional investment company than a publically traded fund perhaps explains why gearing levels are so high: in 3i's case net debt was £2.1bn in December 2008.

During the boom years, when investors were clamouring to gain exposure to the buyout space, there became something of a drive among the larger brands to adopt this model and raise large sums through flotation. Blackstone was the most high profile convert: its listing at the peak of the market in June 2007 saw a 13% stake in the business listed, raising in excess of $4bn.

KKR also announced its intention to go public at around the same time, though the problems that these larger firms have endured since the credit crunch first emerged in late 2007 has caused this to be delayed on several occasions. The firm may have had a lucky escape: Blackstone's share price has dropped by more than two thirds since its listing from $31 to less than $10.

That these larger firms have seen their bubble burst perhaps explains the zest with which the press have attacked the listed space. "3i and Candover are huge names in the industry and for many years they were the golden boys, which is why they've grabbed the headlines - a fall from grace always makes the news," comments Tim Syder of Electra Partners.

Gaining trust

But the furore surrounding these high-profile casualties has clouded the view of listed private equity; a space that is represented in the most part by smaller, privately-held core mid-market firms with a publically traded investment trust. The benefits of having investment trust status are clear: such vehicles reinvest all the proceeds from divestments and thus are not required to pay capital gains tax.

The way this model is applied means that such vehicles, in contrast to the criticism levelled at both 3i and Candover, typically carry little or no leverage and in fact often hold surplus capital on their balance sheets. Often highlighted as representing inefficiency, this now means that such funds are in a favourable position in comparison to many traditional limited partnership vehicles. "Our trust is currently 49% cash - at one time that might have been labelled inefficient and some shareholders might have exerted pressure on us to invest or return the capital. We saw little merit in this argument and are now able to exploit the best market for new deals in decades," explains Ian Armitage of HgCapital.

Moreover, having cash on the balance sheet not only removes the need to go back to often liquidity-starved investors to fund new deals, it also alleviates the potential problem of poor performance-killing future fundraising. "Having permanent capital has its advantages. LP funds that are currently looking at poor performance and distributions may find it difficult to raise new funds. We don't rely on new investor commitments and instead reinvest our returns. There is also no requirement for us to return capital to shareholders," notes Syder.

This freedom from the constraints of limited partner relationships has allowed some managers of investment trusts to adopt much broader investment remits than would be allowed in a standard fund. Electra, for example, has the flexibility to invest in "anything unquoted", according to Syder, and has a portfolio that encompasses buyout, growth capital, mezzanine, third party private equity funds and secondaries, among others. "We can be very opportunistic; right now we're looking at 'money in' deals to help companies with reduced access to capital, but we're also looking at opportunities such as 'stressed' debt," he continues.

Investor benefits

With proceeds from divestments being reinvested back into the fund, investors buying into publically quoted investment trusts do not receive dividends on their shares beyond a small amount whenever there is additional income (a legal requirement). Despite this, there are several advantages to investing in such vehicles as opposed to committing to a traditional limited partnership.

Indeed, the very fact that profits are generated through share price gain over the period of ownership is beneficial in that it offers exposure to private equity for the price of one share. Perhaps more significantly in the current market the same is also true in reverse, in that a sale of an interest is easily achieved at a known price - a stark contrast to the murky world of secondary market sales for those exiting limited partnership funds.

Share price gain as a model for growth has a good track record: leaving aside a sharp dip recently, listed private equity has substantially outperformed the FTSE all-share index for the last decade. And even when shares do plummet as they have in the past six months, this has no real effect on the trust's day-to-day activities. "The share price has no impact on the fund's ability to invest. We do have an obligation to support the share price but to be frank our prime focus has to be on making the best investments we can; firms who focus on share price are concentrating on the short term voting machine," says Armitage.

Investors in listed funds also benefit from visibility in terms of what they are backing. Committing to an LP fund is essentially investing in a blind pool, whereas in a listed fund you can see what is already in the portfolio and in most cases you can see a long track record on which to base future expectations. With so much talk of legacy portfolio issues and the unreliability of big name brands, such openness and proven downturn experience is likely to be very attractive to institutional investors.

Well positioned

Of course, there are downsides to the investment trust model. Firstly, as the recent drop in share prices emphasises, stocks in listed funds are typically undervalued compared to their NAV as a result of uncertainty over the valuation of unquoted assets. "We have always traded at a discount and the perception of this can be negative, but this is inevitable as valuations are very imprecise. Most, though, don't read too much into this and rather judge on track record," Syder confirms.

There are also restrictions on the fund's activities if it has investment trust status in order to justify the tax benefits. Some of these are similar to those common in LP vehicles - such as a maximum exposure of 15% of total capital in one asset - while others are more problematic; most notably the fact that only 15% of the fund can be represented by controlling interests. To get around this, GPs targeting buyouts typically manage an LP vehicle alongside the trust, which invests on a pro rata basis and allows the firm to take controlling stakes while the listed vehicle controls only a minority holding.

Although this means that investment trusts therefore do not represent a distinct alternative to the traditional fund model, the benefits offered to both GPs and LPs mean that, in contrast to recent press assertions, listed funds can be a useful supplement. Furthermore, by providing abundant liquidity and carrying less pressure in terms of returns, they provide managers with greater flexibility to exploit the opportunities that will inevitably arise in the coming months.

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• Topics
• Fundraising
• UK / Ireland