List-en to my fund

At the height of the liquidity bubble, many firms looked into the viability of listing a direct investment fund, a fund-of-fund or even a portion of the management company. A number of firms did list a fund on a European exchange, including Apollo Management, Carlyle Group, Lehman Brothers and KKR. The most public shelving of an IPO was that of Doughty Hanson, which had planned to raise a €1bn fund on Euronext but was forced to pull the plug when structural issues could not be resolved. In the US, Blackstone pulled off the highest-profile private equity flotation ever, listing a minority interest in its management company, but share performance since has been unimpressive, at times dipping 50% below the initial $31 per-share price. Both Lehman Brothers and KKR are have also seen sharp falls in share price since listing, whilst in both cases net asset value (NAV) has increased.

With investor appetite poor and wide discounts the norm, listing a fund has dropped down the priority list for many firms. However, wide discounts are not the same as lacklustre performance. Analyses of listed private equity returns in the UK reveal that whilst returns in the first year lag behind the FTSE All-Share by 3.6% and the MSCI World Index by 2% they outperform public equities significantly in the longer term; 35.3% over the FTSE All-Share after three years, 105.3% after five years, falling back to 58.3% after 10 years. With such impressive figures, why does demand for listed private equity retreat after a brief spike in appetite in the days following a listing?

Dark days

‘It is no coincidence that discounts started to widen in August,’ states Louisa Symington-Mills, an analyst at ABN AMRO. With the credit crunch starting to bite and private equity expected to be one of the worst areas affected, less sophisticated investors began to reconsider their allocation to the asset class and turned to safer products. ‘Although there are many listed funds of funds on offer, with different focuses in terms of geography, vintage year and strategy, some investors don't appear to differentiate between them,’ states Symington-Mills. With all private equity firms suffering from a collective image problem in the wake of various well-publicised attacks in both Europe and the US, the credit-crunch came at a particularly inopportune moment for listed funds.

However, as the majority of listed funds are structured as closed-end funds, they do not have to fear a mass sell-off that can afflict their open-ended counterparts. Trading at a discount may be a frustration for a manager with well-diversified and cash generative underlying assets, but the closed-end structure provides time to educate investors. Educating before the discount widens too drastically is the challenge facing many listed funds. ‘Private equity funds have a different time horizon to other funds that investors may be more familiar with. Institutional investors do not want to be sitting on a loss and may decide to trade out early,’ says David Currie at Investec.

Real disadvantages

One danger of trading at a wide discount is the potential threat from activist investors buying up the portfolio and forcing managers to liquidate at market value. ‘Discounts to NAV are historically an issue in the investment trust industry and with closed-ended funds generally. Activist and vulture fund investors can present challenges for closed-ended funds should they decide to swoop on an under-valued stock,’ says John Langan at Withers.

Although negative press attention and an unstable macro-economic environment are undoubtedly contributing to the discounts many listed funds are suffering from, the disadvantages to listed funds are not imagined.

The J-curve effect is one reason for investor caution. As analysis of listed private equity reveals, returns in the first year lag behind public stocks as investments are yet to be realised. To mitigate this, an increasing number of managers are trying to ensure that their portfolios have a reasonable level of investment immediately following the IPO, with a view to minimising cash drag.

‘Several funds of funds that came to market in 2007 used a “warehoused assets” approach. This is where a pool of assets is assembled pre-IPO and then transferred to the company upon listing,’ states Symington-Mills. Indeed, listed funds-of-funds especially have an advantage over their LP equivalents in this respect as they can begin to show returns at an earlier stage. ‘Access to seeded portfolios is one of the great benefits of pursuing the listed route,’ states Andrea Lowe at the Initiative for Private Equity Investment Trusts (iPEIT). Lehman Brothers Private Equity Partners, Conversus Capital and HarbourVest Global Private Equity are three firms to have utilised this approach on listing. In HarbourVest’s case the company was 98% invested just four weeks following its IPO.

Another disadvantage is the sometimes illiquid nature of the shares held by investors. Although in theory freely tradable, it is not always easy to find a willing buyer even at a discount. ‘Because many retail investors are not familiar with private equity fund structures they are often reluctant to take a leap into what they see as the unknown,’ says one fund manager. Conversely, those investors with a greater understanding of the asset class tend to hold onto shares which are performing poorly, restricting the ability of other investors to access the fund.

The illiquid nature of private equity and initial cash drag is old news to experienced investors in the asset class. These ‘disadvantages’ are the trade-off for historic returns of between 15-20%. One area where listed funds differ to traditional LP funds is on remuneration.

Fee issues

Alignment of interest is crucial for the success of private equity and although some will argue the point, carry of 20% is well established as a means of aligning interest appropriately. It ensures fund managers are incentivised to work (in most cases) to the end of a fund’s life to maximise value. As a listed fund is evergreen, the same carried interest arrangements aren’t workable. Some listed funds charge carry per investment, such as Euronext-listed KKR Private Equity Investors and Apollo’s AP Alternative Assets, which levies 20%. The majority charge a performance fee based on NAV, subject to a trigger or hurdle. The performance fees charge range from 7.5% to 15% with a hurdle of 8% the norm.

Many benefits

The benefits of listed funds are numerous and well documented. Although illiquidity issues can surface, listed vehicles afford the investor a level of liquidity unique in the private equity fund world. For the manager, a listed fund allows access to a broader investor base. ‘It is a great way for smaller institutional investors and high net-worth individuals to gain exposure to private equity. Investors can write smaller tickets and the process is relatively simple - you just call your broker,’ says Andrew Lebus at Pantheon. He also points out that listed funds can be a useful tool for more established institutional investors looking to grow their allocation. ‘Larger institutional investors can utilise listed funds if they decide to expand their private equity program. They can do it more quickly than if they put money to work through the usual channels.’ Listing a fund is also a useful profile-raising exercise for a private equity firm. ‘It gives you a public face and makes people aware of you in the wider investment world,’ believes Lowe.

The attraction of permanent capital is oft-cited as the main reason for a firm to list a fund. This can be overstated. ‘Permanent capital is just a phrase. LPs come and go regardless of whether you are public or private,’ states Frank Ballantine at Reed Smith Richards Butler. Indeed, a majority of those private equity firms which have chosen to go the listed route are the biggest names whose funds are always oversubscribed. For them, access to capital is not a problem which needs solving. What a listed fund does do is provide greater flexibility, allowing a manager to take advantage of opportunistic investments which may arise. ‘I can’t count the times when I have come across an excellent opportunity but have been unable to act because of various clauses in the LP agreement,’ states one fund-of-fund manager.

A changing mood

Whether listed private equity is the future is up for debate. At present, the mood of optimism which surrounded this space 12 months ago is over. The standard LP fund structure has proven so successful that there is no reason at present to turn away from it. However, some see it as a dated model ready to be challenged by new, innovative structures. ‘There is a supply-side imbalance and as a result the energy is moving from the private to the public market. It is a mystery why LP funds have ten year terms. You end up with two five year cycles, first the initial investment cycle and then the liquidity phase. This warps the business strategy and can prove especially problematic if the economy slows down,’ affirms Ballantine.

For the investor universe to be able to tap the success of an asset class previously restricted to the few would appear too good to be true. The problem is that many investors seem to be observing the adage that if something looks too good to be true it probably is. Only a more forceful process of education with the disadvantages acknowledged will see discounts contract. At present, the discounts at which some listed private equity funds are currently trading represent a keen bargain. A bargain all managers hope will be a strictly limited-time offer only.

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