Head of the Class | Published in September 2006

Hero Worship

Private equity proves to be a sweet spot for institutional investors

By John Keefe | September 2006
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Private equity proves to be a sweet spot for institutional investors

» Slow and Steady—and Diverse—Wins the Race…

» …but You Can Get a Head Start

Every era needs its heroes and, in the markets of 2006, the heroes of institutional investors are the managers of private equity funds. Venture capital activity is subdued but, thanks to low interest rates, accommodating lenders, and debt markets, buyout funds are running at a gallop: Managers have recapitalized companies and declared substantial dividends, and corporate buyers are paying generous valuations for ­refurbished businesses. Lately, a new breed of buyout fund has emerged: global "mega funds" endowed with $10 billion to $15 billion in equity capital, and empowered by the goal of shaping up world-class companies, away from the scrutiny of the public markets. Thus, some buyout partnerships are earning lifetime rates of return of more than 100% and returning capital well ahead of schedule, and the diversified portfolios at giant public pension funds have posted 25% to 30% gains this year and last.

Managers of private equity funds of funds insist that no one can time their market, or predict when opportunities will be available and, to no one's surprise, advise institutions to add to their allocations every year. However, astute sponsors are reaching the same conclusion with good reason: The $29 billion Pennsylvania State Employees' Retirement System (PSERS), for example, earned 36% on its $2.7 billion buyout stake for the year ended December 2005, and 24% over three years, and, at its June 2006 session, the PSERS board authorized an additional $300 million ­commitment to private equity. The Washington State Investment Board's $8 billion of private equity earned 37% for the year ended March 2006, and 27% for three years. "We're right at our target allocation of 17%, and we'll more than likely be going to our board to increase that," reports Gary Bruebaker, head of the Evergreen State's $54 billion plan.

Managers of private equity judge the state of their markets not just from the returns they realize on the investments they have ­refurbished and refinanced, but from ­indicators on the many cycles in their ­business: the flows of fresh capital from institutions, and the amount of capital private equity funds have turned away; the ability to deploy funds in new venture or buyout investments, and the prices of those deals; the availability and price of loans and ­high-yield debt for leveraged transactions; and the overhang of capital that investors have committed, but general partners have not yet put to work transforming companies. Each of the sectors within private equity—venture capital, buyouts, mezzanine financing, and distressed debt—follows its own cycle, driven by the state of the economy, technology innovation, and the stock markets.

"We have new entrants to private equity, existing investors trying to fill their allocations, and others raising their allocations from 3% or 5%, to 10% or 15%, even when valuations are at an all-time high," notes Charles van Horne, managing director at Abbott Capital, an independent fund of funds manager in New York, overseeing $6 billion in private equity.   "Only 40% of institutions are at 90% or more of their targeted allocation," he adds, "and the overhang of capital is said to be $300 billion."

At the other end of the private equity market, in venture capital, the appetite of institutions for new investment is still depressed. Venture investors still are feeling the scars of the tech bubble, so money is chasing deals at a slower pace.   "These days, venture companies are priced pretty well," at least from the investing perspective, notes Kevin Delbridge, senior managing director at HarbourVest Partners in Boston. "Getting out of venture capital   companies is pretty hard, though, because there is not much of an IPO market." Venture capital funds exited half of their investments through IPOs and half through mergers and ­acquisitions 10 years ago, says Mary Kelley, a general partner in INVESCO's private equity arm in Denver, but, in the past year, stock flotations have made up just 10% of venture capital sales: "The IPO market has not been willing to create ­multibillion-dollar market caps from companies that don't show tangible strength."

The distressed debt segment of private equity is in a valley as well, observes Anthony Tutrone, head of private equity funds of funds for Lehman Brothers in New York. A strong economy has been a help to ­companies of all shapes and sizes; more important, plentiful loan and debt markets and low interest rates have kept afloat companies that might have gone to the brink in times of tighter credit. However, with weakness emerging in the US housing sector, distressed investors expect high-yield bond defaults to recover from their cyclical lows, and look forward to busier times.


Slow and Steady—and Diverse—Wins the Race…

"When you see gaudy returns in private equity, like 25% to 35%, you have to take a step back, because the return over a longer period is in the high teens," cautions Jeffrey Hammer, senior managing director at Bear Stearns Asset Management in New York. "If you take a long-term holistic view, and allocate across buyout and venture, as well as distressed debt, mezzanine, and natural resources, you'll get returns that are sustained over time across the asset class."   The successful PSERS portfolio contains 102 venture capital investments, 131 buyout positions, and 21 distressed debt funds, in both direct funds and funds of funds, both in the US and overseas. More modest plans can diversify by investing with a fund of private equity funds; a typical fund of funds will have a stake in 25 to 30 private equity funds, each of which might make 15 to 10 direct investments.

"You have to invest through the cycle," advises Tutrone, irrespective of where prices happen to be. "We don't think you can time the market and, for a typical program, we expect to invest our partners' capital over three to five years." "Over the 10-year life of a private equity fund, the fundraising cycle will shift a couple of times, the cycle of pricing deals will change, and the exit environment will move around," notes Kevin Delbridge, senior managing director at fund of funds manager HarbourVest Partners in Boston. However, he cautions, "In private equity, you can't say 'this is a great time to overcommit' or 'this is the year we should stay out.' You have to average in, and average out. It takes the underlying funds three to four years to build their portfolios and work the cycles."


…but You Can Get a Head Start

Private equity's exclusivity and mystery does not guarantee high returns: Thomson Venture Economics reports that, in the 20 years ended December 2005, the median annualized return of all private equity funds was just 5.2%, versus 12.7% for the more pedestrian S&P 500. The return for the top-quartile manager, however, averaged 16.3%, and the spread between the top- and bottom-quartile return was about 20 percentage points.

The potential for disappointment in manager results can be offset by private equity's higher visibility. "The return ­statistics say that there is a higher probability of repeat success in private equity," notes Tutrone. "That fact and the vast outperformance of top managers make private equity a unique asset class.

"We have a database of returns for about 300 funds over a range of vintage years, and we've found that there's virtually no correlation between return and fund size, or geography, or vintage year, or anything else, except prior returns. About 45% of managers that produce a top-quartile fund will produce a successor in the top quartile. The second point," he continues, "is that more than half of top-quartile managers won't produce a top-quartile successor. Past performance is a good starting point, but it's not an investigation in itself."

"In the end, we're value investors," observes Mary Kelley of INVESCO. "We have to find the value proposition of the general ­partners we invest in: their operating knowledge in a sector, such as branded consumer products and their ability to expand to global market share, or build out IT systems. We need to know how they achieve sustainable growth, and what their exits will be."

"The buyout cycle is probably getting toward a peak," says Tutrone. "We can't time these markets; all we can do is give our money to the best people."