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Private equity: an oasis in the investment desert?

The private equity industry has had a difficult couple of years, yet it is still proving popular among family offices

Hindsight often says that the best time to invest is when an industry is down. And many are questioning whether this is the case with private equity.

The sector in its current form has been around for a relatively short time. But in the past year it has certainly had a massive shakeout, albeit after a spectacular run between 2002 and 2007, when it was definitely a case of let the good times' role. Pension funds and other investors as well as bankers threw record amounts at an industry that was one of the key beneficiaries of low interest rates.

During its golden period both the number and value of deals proliferated. In 1995 there were less than 100 deals done in the sector worth an average of £10 million. By 2006, this reached close to 1200 deals at £600 million, according to Dealogic.

Now it's a different story. Deal flow – the life blood of the private equity market – has slowed back down to a trickle. The number of deals being done is below 200 and their average value is sub 1995 levels. Investors are reticent about handing over funds – even those that are committed. Bankers are also retreating from private equity, which relied heavily on loans based on collateralised loan obligations that are no longer widely available.

In spite of its current difficulties, many family investment groups continue to believe in the private equity sector. But their involvement in the sector is more to do with the historical affiliation the families have with private businesses and less to do with issues associated with investment timing.

David D Murray is the managing director of Murray Capital – a family business based in Edinburgh, Scotland, which originally made its money from trading in steel. About 70% of this family's assets are in private equity, but half of this figure relates to the original family business of steel trading, which his father is in charge of.

Murray is in charge of the portfolio of investments and when it comes to investing in private equity funds, his family is sticking to those investments where it feels it has a significant element of control over the investment decisions. This means investing directly in companies, or with other families or funds. When it comes to investing in actual funds, his upbeat tone lowers: "We are not going to invest in traditional private equity funds and get charged two and 20 for the privilege. I believe those days are long gone." He is referring to funds that charge management fees of 2% on funds held and monies committed, plus the 20% "carry" referring to profits made on investments once exited.

Less than 5% of his family's funds lie in the hands of managers, Murray says and he and two others sit on the boards of companies that his family has invested in directly.

Private equity, in the eyes of many, only came into existence after the leveraged buyout by Kohlberg Kravis and Roberts (KKR) of RJR Nabisco for $25 billion, then the largest deal of its type ever done. This might seem a long time ago in the eyes of the ex-management consults and investment bankers that now inhabit the industry, but it was only in 1986.

Yet Ingleside Investors, a family office based in New York, has been involved in private equity for much of its history since first making its money in the early 1900s in commodities trading. For example, it sold a controlling stake in US-based Peoples Drug Stores to a subsidiary of British American Tobacco in the early 1980s. Its first investment in private equity as it is known today was in 1986 to KKR.

Today the family operates in a similar way to endowment funds, according to its managing director Scott Earthy. It has a 50% allocation to private equity and invests in a total of 140 funds. It also co-invests with private equity companies in companies as a minority investor. Plus, it invests in companies on its own.

Earthy says that although its investments in private equity are hard to exit, or illiquid, its investment horizon is long-term, meaning longer than five years, so that isn't a problem: "You can't easily time the market if you're investing in (private equity) funds since you ultimately don't make the decision as to when the money is invested in a company."

He continues to believe in the premium return provided by private equity over publicly listed shares, given the former investment's lack of liquidity. But at the same time, given the current climate, Earthy admits that there are issues around "managing liquidity". In the past, when committed funds were called by one private equity company, this was managed by cash inflow from another, in the form of returns. Today, however, because of the difficulty many private equity companies are having exiting investments, few, if any returns are coming his way.

"Ultimately deal volume will pick up again and when it does, if we've made a commitment, we have to have enough money to honour it. As an LP, you can't control the exact investment timing, which is why we aren't aggressively making new commitments," says Earthy. "Right now, we have a big uncalled commitment balance to work our way through."

But the sector's experts are more sanguine about its prospects. Despite the difficult environment for private equity, some academics that have followed the sector are saying that right now is the best time to invest.

"There is a broad dispersion across managers' (returns), but by and large, funds raising when periods are least attractive are the ones that do the best," says Josh Lerner, Jacob Schiff Professor of investment banking at Harvard Business School.

One of the key reasons for this, according to Lerner, is supply and demand: "During the rough periods, poorer groups find it harder to raise money," hence there is lower demand for assets and more favourable prices available to prospective purchasers, which include well-funded private equity companies.

According to Venture Economics, an arm of the Thompson Media, between 2001 and 2003 private equity achieved an internal rate of return as high as 20%, compared to publicly listed equity, which only just broke even. There is also evidence, according to this group, that private equity produces returns of up to 300 basis points higher than investments in publicly listed companies.

Mounir Guen, CEO of independent international private equity placement agent MVison, is confident that the sector has learned its own lessons from the past few years. He claims that while 2007-2008 was a period of excess, 2008-2009 was barren but served as a cleansing period for those on the sell-side. "Just as investors have recalibrated their investments, so the private equity industry has been through a reassessment and readjustment. Everyone realises that they have to get back to driving value for investors," he explains.

In addition, he says that alignment of interest is key and that, crucially, the industry has recognised this, which bodes for the future.

According to both Earthy and Murray, the key to ultimate success in this asset class is not what you know, but who you know. And this is where the respective families' networks kick in.

For one thing, security in the asset class is provided by being assured that you have picked the right management.

"If you've picked quality management you are less concerned about returns today, or the unrealised return. What's more important is future cash flows," says Earthy.

Choosing the right manager involves lots of reference checking, but not from other fund managers. "You have to use your network, which includes other families investing in private equity as well as company chief executives and former employees of the fund," he says.

A good sign is also if the private equity manager itself has put significant amounts of capital into the fund. Beyond this it is essential to research the managers experience and track record and whether the company has solid succession planning in place, according to Earthy.

Another important consideration is the size of the private equity fund.

Larger funds such as those associated with KKR, Apax Partners and Carlyle Group have funds that are over $10 billion. Many, including Earthy, believe that these funds are more associated with generating massive fees than with superior performance for the investors, or "limited partners".

Consequently, more specialised funds of between £500 million and £2.5 billion are favoured by many investors. One of these funds is Lyceum Capital which invests in companies with enterprise values between £10 million and £75 million and are service providers located in the United Kingdom. One of its directors, Andrew Aylwyn, says that if an investor has £50 million, he wouldn't want any more than £10 million in single a fund. Furthermore, he says that a better exposure for those investors could well be fund of fund type investments that invest in a number of private equity vehicles.

This is definitely food for thought for investors in a sector that has proven to be a much higher risk than was believed not less than two years ago.

On the other hand, David Murray is adamant that his philosophy of direct investment in companies will continue to protect the capital value of his family.

The only change to his strategy, he says, is to look for other families to co-invest with. He admits that there is a risk, for example, that one family wants or needs to exit before the other.

"Hopefully when we go in (as an investor with another family), we go in with like-minded people where we are aligned with," he says. Many would agree with these sentiments.

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