Favourable supply dynamics, unique manager teams, diversification benefits and the potential for strong long-term returns make private equity an attractive investment option.

Alternative assets cover a wide and ever-expanding range of options for today’s institutional investor including private equity, a non-traditional asset class invested in companies that are not publicly traded. More specifically, private equity refers to the manner in which the funds have been raised—through private investment as opposed to the public markets.

Gaining Momentum

According to Private Equity Intelligence (a London-based data firm), 2007 was a banner year for the private equity market, as management fees collected (excluding performance-based transaction fees) totalled US$33 billion—up 20% from 2006. Canada’s Venture Capital & Private Equity Association also reported a $10.5 billion yearover- year increase in the total value of announced buyouts of Canadian companies in 2007 (excluding the $46.8-billion acquisition of BCE, pending at press time) to $18.7 billion across 181 deals—up from 105 deals in 2006.

Looking forward, a 2008 study of 125 private equity professionals by Blake, Cassels & Graydon LLP found that almost 40% of respondents view pension funds as new sources of capital in the near-term. The majority of participants also believe that institutional investors have been the most influential factor in the growth of private equity in Canada. With such demand, supply has grown as well, resulting in more opportunities to invest.

Investment Decisions

Combine these favourable supply dynamics with historically low observed correlations to traditional asset classes and the case for private equity investment is strong. The question that remains, however, is how much to invest. Factoring in plan size and existing asset mix, typical allocations range from 10% to 15%.

Pension plan sponsors should also give careful consideration to timing and manager selection. A fund’s vintage year—the year in which the fund was raised—can have a meaningful impact on returns. However, timing the private equity market is, intuitively, at least as difficult as timing the public market. As it often takes a number of years before private equity assets begin generating positive returns, private equity is likely best suited for a buy-and-hold investor. That said, those considering private equity investment may want to view it as an ongoing commitment rather than as a one-time investment.

Compounding the timing issue is a significant gap between top-performing private equity managers and the rest of their peer group. Active management by experienced managers with both financial and operational expertise remains a key element of success. In fact, one could argue that committing funds to the right manager is more important than committing funds at the right time. Plan sponsors should carefully assess the manager’s team, investment process, results from portfolio company investments, deal flow and risk management framework before investing.

Related Link

There are a number of ways to invest in private equity: through a private equity fund (primary investment), through a fund-of-funds manager, through co-investment, through direct ownership of a target company or through the purchase of an existing limited partner’s private equity fund interest (secondary investment). As with any new investment, it’s important to undertake an in-depth analysis and assessment of fit before investing.

The Future for Private Equity

While the credit crisis may have cast a shadow on the global capital markets, opportunities in the private equity area haven’t necessarily subsided. Although lenders have become more risk-averse and have dramatically reduced the supply of capital, private equity transaction structures are becoming less complex, and buyers have modified their pricing structures and return expectations. Demand continues to be strong, particularly in the small to mid-market, and non-U.S. markets will likely offer increased opportunity going forward.

Private equity may not be the right choice for every plan, but it offers unique features, as well as the potential for significant upside and overall risk mitigation. It’s an alternative that plan sponsors should at least consider.

Darren Patrick is an investment consultant in Hewitt Associates’ Vancouver office. darren.patrick@hewitt.com

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the June 2008 edition of BENEFITS CANADA magazine.