In defence of private equity

That eurobonds outperformed European private equity on a 10-year time-horizon by nearly 300 basis points is not great marketing for the industry. No wonder investors are fed up. But not all. "The backlash has created some great opportunity sets to invest in the asset class," says David Holmgren, CIO of Hartford HealthCare Systems. His view is particularly salient given Hartford's lack of any private equity investment history: in fact, the institution only made its first strategic allocation to the asset in February, earmarking 6% of its $1.8bn in pension and endowment assets to private equity.

Why is Hartford entering as others threaten to exit? Because there remain GPs worth backing. The industry's underperformance is based on aggregates and averages, which tend to overlook overachievers while rewarding underperformers. Private equity isn't about backing an index; it's about selecting the managers best placed to generate alpha.

The past two years have seen some outstanding performances, some from erstwhile little-heard-of names. DN Capital, Equistone, Growth Capital Partners, Isis, LDC, Maven, Mobeus, PAI and Permira all recorded multiple strong exits. Some had truly standout years: Mobeus, for example, clocked up six exits generating £56.4m against cost of £13.3m in the 12 months to July 2012. DN generated €58.5m (including amounts in escrow) on a cost of €13.6m - 4.3x in the 18 months to August 2012. Isis clocked up seven exits with an average gross return of 3.9x and 35% IRR in the 12 months to June 2012. During its 18-month fundraise, Equistone returned €2.2bn to LPs from 15 exits (2.7x the cost of those deals).

Rewind the clock five years and few would have guessed PAI and Permira would go on to make the list of top European performers. But sometimes reputational setbacks facilitate effective evolution. "Going through a period like that forced us to assess what we do well, focus and do more of it," says Kurt Björklund, co-managing partner at Permira. Indeed, Permira, which reduced the size of its previous fund just four years ago, clocked up a hefty €3.4bn of proceeds for 2012. Two exits in particular stood out: Galaxy in China netted €1.1bn for the GP, while NDS netted €800m. "Last year was the best year we've ever had on many metrics," says Björklund. Meanwhile, PAI returned €4.6bn in an 18-month period during 2011-2012 across six exits, according to a source.

Between 2011 and 2012, unquote" data compiled a list of 80 strong exits that generated IRRs of 30% or more, or a money multiple of at least 4x. The true figure is higher, as purchaser pricing sensitivity prevents some of the best returns from being disclosed publicly. December 2012 alone clocked up €15bn of exit proceeds in Europe.

These figures are impressive given the toughest backdrop the market has known, indicating houses are hard at work generating proceeds. This "search for alpha" is very different to the high-growth leverage plays endemic in the heyday. "If a manager made a return in a market that no longer exists, he wasn't adding value all along the food chain. It was just a beta play and we won't consider them," says Holmgren. Now that the beta-wave has come crashing down, finding these managers is critical.

Buyers beware
Comparing 2011 and 2012's 80 strong exits with previous two-year periods underlines LP disappointment with the asset class. In 2009 and 2010, 111 strong European exits were recorded by unquote". For the previous two years (2007-08) this stood at 198. So across the industry, lucrative realisations are waning, meaning it's all about selecting the right fund manager.

But isn't this old news? The increasing noise from disgruntled investors begs the question of how limited partners are making their investment choices.

All too often, fund manager selection has been dictated by the need to deploy large chunks of money - and thereby precludes small houses. LPs have been likened to sheep for their tendency to follow a leader.

"I see it as a 20-year-old's version of ‘safe sex'. It's considered safe if everyone else is doing it. Too many LPs think they're smart (and even prudent) by copying other LPs, but we see that herding mentality as quite dangerous," says Holmgren.

Holmgren brings with him multiple years as a top-quartile industry investor. For 2012, Hartford HealthCare was in the top 15th percentile of all endowment funds. "There's a proper time and way to deploy capital and right now it's very advantageous to move from an opportunistic approach to a formal policy to dedicate a set amount to private equity. We're acting on our convictions here - brief pockets aside, the trade-off between liquid assets and illiquid has been unfavourable for years."

Hartford is unusual, though not alone, in seeking out private equity exposure now. In fact, almost a third of European insurers say they will increase their allocation to private equity and hedge funds in a search for yield, despite the higher capital charges under Solvency II, according to a poll of 223 insurers conducted by BlackRock.

Vote with your feet
For all the talk of LP disenchantment with private equity returns, very few are truly walking away. A recent study conducted by Pensions & Investments reveals the gusto with which some top UK pension funds back the asset class - and indicates that the higher a fund ranked, the higher its allocation to private equity. The top 10 highest-performing UK pension funds allocated 3.9% to private equity, while the top 50 figure was 2.8%, according to this inaugural survey of 50 funds, which manage a combined £513bn in assets. The survey went on to say not all corporate pension funds are reducing risk, citing BP Pension Scheme as an example, which dedicates 11% of its £15.6bn to private equity.A problem with fund manager selection is that brand often plays too large a role - especially for institutions with investment teams ill-equipped to assess smaller funds. This is partly driving the herd mentality.

"The LP needs to define what they want," Holmgren explains. "There is often a fundamental break - when a small local pension fund, for example, looks at large-cap buyouts - it's entirely outside their culture."

And they often look to tick boxes rather than seek out top performers. "We don't start with any sort of restriction; we are looking at expected returns first and foremost," says Holmgren.

Now, more than ever, this will come from effective management, which has been absent in most GPs in the past few years, according to Holmgren. "We see 90% of GPs lacking in portfolio management... you can distil them to simply a levered beta play. They talk up their origination function and exit ability, but what about value-add?"

Martin Goddard, global service line leader in transactions at Grant Thornton, says: "The private equity community has to make returns outside of just arbitrage - they need to add value to really succeed now."

PAI exemplified this with Yoplait. Says Michel Paris, CIO at PAI: "We held a stake in Yoplait for almost 10 years, which is a long time for a private equity investment, but there was a significant amount of work to be done at the company. The first phase was to revive the operations and the marketing approach. Once progress had been achieved in these areas, we focused on internationalisation and replicated the success of Yoplait's consumer brands in new markets." It paid off, with a 10x money multiple in 2011. Just two months after the Yoplait sale, PAI sold Compagnie Européenne de Prévoyance for more than 15x money and SPIE for nearly 5x money.

At Permira, portfolio management is the responsibility of all, rather than a dedicated team. Says Björklund: "Crucially, we don't believe in a model where one part of the team originates and another monitors. There is one team for the life of the investment. It's a very simple nucleus of the private equity model: what do you want to achieve in four to five years' time? Then devise a strategy with management and align your interests."

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• Topics
• LPs
• GPs
• Fundraising
• PAI Partners
• Permira