Low Correlations
Private equity markets have a well-documented low correlation to the public markets. This is because private equity funds own companies, not just securities, representing whole businesses with real revenues, cash flows and assets. Successful buyout firms acquire companies based on an investment thesis developed over many months of due diligence—a plan to build the value of the business over a period of several years. Turmoil in the financial markets may affect financing plans or the timing of a potential exit, but it rarely has a direct impact on the company’s fundamental business strategy. Venture capital has a similar set of uncorrelated drivers of performance. The development of new technologies and innovative business models has its own risks and rewards, but these are one step removed from the financial market turmoil. Of course, we still remember the dot-com crash of 2000/01 that affected the venture capital sector. However, this period also marked the rise of Google, YouTube and other star performers focused on innovation, whose success transcended market conditions.
Stress Points
While the two asset types are very different, there are two important stress points where the public markets can have a direct impact on private equity performance. First, any privately held company needing fresh capital has a more difficult financing task when the public markets are in trouble. Indeed, in the tumultuous market conditions of September and October 2008, few companies—public or private—have been able to access new funding. Those companies fortunate enough to have the support of well-capitalized private equity firms are among the lucky exceptions to this rule.
Experienced private equity firms always enter into a new investment with an initial financing commitment while reserving additional capital from their funds for any anticipated follow-on rounds of financing. Of course, the world does not always unfold according to plan, and portfolio companies may require unanticipated capital infusions at times of stress. However, in many cases, the necessary capital is available from friendly private equity firms that already have a stake in the company, know the business intimately and are in a position to respond quickly.
This ability to access friendly capital is obviously not universal. It is not unusual for private equity firms to make tough decisions during periods of market stress, choosing to support only the more promising companies—particularly if the private equity fund’s own resources are limited. Investors may be reluctant to fund an unexpected cash shortfall if it means cannibalizing resources set aside for stronger portfolio companies. These types of follow-on rounds work best for smaller mid-market or emerging growth companies and are less likely to succeed for larger capitalization portfolios.
The second stress point comes from the break in the exit market. Portfolio companies that have executed the investment thesis and are ready to be sold will find limited exit options in these market conditions. When the public markets are closed to new issues, even strong portfolio companies cannot achieve the liquidity desired by investors. The exit market for strategic buyers also slows down in these conditions, although it rarely stops completely.
These conditions can be frustrating to private equity investors who have worked hard to build their companies to this stage, only to find that they are unable to achieve the expected realization on their investment. Typically, the investor will simply choose to hold the company for a longer period until market conditions improve. For a business that is performing well, this delay to liquidity is not usually a serious problem.
The other result of this kind of market stress is a drop in prices for new investments. The high stress in the public markets, along with the tight market for bank financing, has put private equity funds in a preferred negotiating position for prospective new portfolio companies that need to raise capital, either for growth or for ownership renewal. This buyers’ market for private equity exists today and is evident in the high-quality investment opportunities now flowing to private equity firms, many of which are being offered at lower prices than in prior years. It certainly appears that 2008/09 vintage funds are likely to show strong returns against historical benchmarks. Put simply, investors seeking to buy low and sell high are in open pursuit of companies in the private markets.
How to Diversify
In a rising market, it is much easier for investors to achieve strong performance. For example, a broad range of private equity firms showed strong returns in the period leading up to the mid-2007 market peak. Today’s market conditions are more challenging, and during these periods of stress, weaker fund managers are separated from strong ones. Fund selection is of critical importance in this environment, as the variance between top quartile and lower quartile returns can grow dramatically.
For institutional investors, the proper approach to risk management in private equity requires a diversified portfolio. Selecting a portfolio of fund managers with different investment styles—and diversified by size, sector and geographic focus—is recommended.
Many institutions also seek a balance between investments into funds to manage risk and direct investments into companies alongside their investee funds (known as co-investments) for additional returns. This balanced approach can be seen in the portfolios of the large Canadian pension funds, most of which are active private equity investors with allocations to this asset class in the range of 10% to 15% of their total capital. These investors have built sizable internal teams that track the private equity market and co-invest directly alongside a variety of private equity funds. This combination of active coinvestment programs, comprehensive fund manager due diligence and a well-developed portfolio strategy has led to strong returns and effective risk management.
For those institutions that do not have the resources or the desire to build their own private equity investment teams, a private equity fund-of-funds provides an effective alternative. Investors should note that the additional fees associated with a fund-of-funds are comparable to the internal costs incurred by the large pension funds that have built their own specialized internal teams.
Some institutions prefer a hybrid approach to private equity, with an initial investment in a fund-of-funds for part of their allocations supplemented by their own independent selections. Many fund-of-funds managers in this sector will routinely share market intelligence and due diligence information with their own limited partners to assist them with this type of hybrid strategy.
Recent events have highlighted the benefits of investing in private equity. Institutional investors should not sit on the sidelines and miss this important cyclical opportunity merely because they do not have an internal team dedicated to the sector.
Rick Nathan is chair of the Canadian Venture Capital Association and managing director of Kensington Capital Partners Limited. rnathan@kcpl.ca
For a PDF of this article, click here.
