What And Where Are The Returns In Private Equity?
By: George J. Engman
While private equity may be a natural complement to a traditional portfolio, Canadian pension funds have been slow to embrace this asset class. George J. Engman, of Integrated Partners, appreciates the reasons for this reluctance, but believes the category deserves closer scrutiny.
Virtually all plan sponsors now accept that conventional assets and the traditional asset allocation alone are no longer sufficient to meet their funding requirements. In order to meet their obligations, and eliminate deficits, sustained real returns on the order of 4.5 per cent to five per cent will be required.
A key element of the solution lies in the world of alternatives. For many leading pension funds, real estate has already become a core asset class. But they have also moved to expand their portfolio of alternatives to include hedge funds, private equity, and private debt. The more advanced have also gone into more specialized asset classes such as commodities and infrastructure.
On the face of it, private equity is a natural complement to a traditional portfolio. Private equity offers a superior risk to return relationship over equity investments in the traditional public markets. Unlike public market investors, private equity investors exercise considerable control over their investments. This is an asset class which is particularly susceptible to manager skill, with the opportunity for exceptional returns.
As Table 1 indicates, some funds have made sufficient commitments to private equity. Ontario Teachers’ estimate that its Merchant Bank represents more than 10 per cent of all private equity and mezzanine debt capital in Canada.
Commitments on that scale can be highly rewarding. In its most recent annual report, Ontario Teachers’ noted that since 1991 its merchant bank had invested in more than 100 companies and 25 private equity funds, realizing a rate of return in excess of 25 per cent per annum. The Canada Pension Plan Investment Board (CPPIB) has a current target allocation for private equity of 10 per cent and has committed some $5 billion so far.
The CPPIB asset mix policy indicates it expects up to 15 per cent of the total CPP investment portfolio will be private market investments.
As is so often the case, commitment to private equity in Canada lags behind that in the United States. Private equity in the United States is a well-established asset class for pension funds, endowments, and foundations. A recent common fund study of more than 600 institutions with more than C$260 billion in assets found that the average allocation to private equity by funds with more than $1 billion in assets was nine per cent.
One of the most outstanding examples of private equity commitment is the legendary Yale University Endowment Fund – one of the most successful endowment portfolios anywhere. Over the last 10 years, this US$10 billion fund achieved annual net investment returns of 16.9 per cent and returns averaged 17 per cent per annum over the last 20 years. Yale’s current private equity allocation target is 17.5 per cent and its total exposure has been as high as 25 per cent. It has made its allocation with an expected real return of 12 per cent on its private equity portfolio.
The private equity market in Canada, estimated to be approximately $49 billion, is showing some modest growth. Of this total, around 40 per cent is believed to be in institutional portfolios. A2003 study by Goodman and Carr LLP, based on research conducted by MacDonald & Associates Limited, found some encouraging signs. While they noted the reluctance of Canadian institutions, relative to their U.S. counterparts, to get into private equity, new institutional commitments to LPs were significantly greater in 2002 than in the previous year and they estimate that more than $7.5 billion has been added to the total private equity pool since January 2000.
The question that naturally results is ‘why are Canadian pension funds so reluctant to move into private equity?’ Part of the explanation lies in the numbers or, to be more precise, the lack thereof. There is very limited information available and what does exist is often incomplete and misunderstood.
The first and most superficial impediment is the so-called J-curve. AJ-curve results from plotting the returns of a private equity fund against time, from inception to termination (Chart 1). Because the management fees and start-up costs are typically paid out during the first drawdown, a private equity fund will initially show a negative return. Once the realizations on the investments begin, the fund returns begin to rise steeply. Somewhere between three and five years from inception, the interim Internal Rate of Return (IRR) will begin to give a fair indication of the final IRR. This interval is typically shorter for buyout funds than for early-stage funds.
While this makes perfectly good sense, it can be a hurdle for a committee coming to private equity for the first time. It is in the nature of private equity investing that in the early years of a fund, returns are often low or negative. Patience is the essence of private equity investing and patience is typically rewarded. Acontinuing program of commitment to private equity will mitigate this effect over time and provide the desired result.
There is virtually no universe of private equity return data in Canada. One can, however, get a rough appreciation for the potential by comparing Canadian and U.S. public equity returns to U.S. private equity returns (Table 2).
Difficult To Interpret
Unfortunately, the data is very difficult to interpret. However, there are some truly remarkable surprises lurking within. The natural tendency is for the asset mix decision- makers to apply the attributes of public equity portfolio managers to the managers of private equity funds. Traditional equity portfolio managers have investment styles, such as earnings growth or value, which are cyclical in nature. Acertain investment style will produce good results at certain points in the economic cycle, or during certain market conditions, and bad results at other times. As a result, the probability of traditional managers consistently outperforming the market is very low. This observation has been borne out by extensive research over the years and is a significant contributing factor to the growth of index investing.
In direct contrast, private equity investing is characterized by a very labour intensive process where the managers can obtain a superior risk-to-return relationship through, among other things, access to high quality, nonpublic information; a direct and close relationship with the portfolio companies’ management teams; and binding legal rights obtained through shareholder agreements and employment contracts.
However, this requires a number of highly specialized skill sets:
- deal structuring skills
- due diligence expertise
- the experience and knowledge of a seasoned director
- negotiating expertise
- comprehensive understanding of valuation processes
This combination of skills is usually found in a team whose members would have experience in investment banking, accounting, corporate governance, and money management. However, the style would be independent of the economic and market cycle.
Hides Important Fact
Relating to the statistics, private equity fund managers will only make available their returns if the information is kept confidential and only published at the aggregate level, which hides an important fact. It conceals the reality that certain private equity managers, who have mastered the process, consistently produce superior results.
Further, since the spread between returns of private equity managers is far greater than that of public equity managers, the scope for consistently good managers to add value to the overall asset mix is quite high. The dispersion is breathtaking. Astudy by Frank Russell and Venture Economics found that for the period 1991 to 2001 the first to third quartile spread for U.S. Large Cap was 180 basis points (bps) and for U.S. Small Cap 280 bps. For U.S. Private Equity, it was 2,140 bps.
The other statistical difficulty with private equity is that because it is managed in discrete limited partnerships, the returns are measured in terms of the IRR, either on an interim basis or over the life of the fund. Unfortunately, IRRs cannot be treated in the same way as monthly return data used in the asset/liability model and, therefore, cannot be quantitatively represented in the normal asset mix as real estate, hedge funds, or managed futures can.
One way of dealing with this would be to argue that private equity opportunities should be pursued in those geographical areas where an institutional asset mix calls for public equity investment since private equity should produce investments with a superior risk/return relationship, thus theoretically pushing out the efficient frontier.
George J. Engman is president and chief executive officer of Integrated Partners.
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