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Wealth management and the joy of illiquid assets

Scott McCulloch is editor of Families in Business magazine.

Global competitive pressures mean many of Europe's family businesses will need to divest their non-core activities or raise fresh capital. Wealth managers say this will increase investor exposure to private equity. What happens next, asks Scott McCulloch

Some commentators believe that investing in private equity goes against everything the textbooks recommend as an appropriate investment. The funds are mainly illiquid and the risk inherent in the portfolio companies chosen by wealth managers can be stratospheric.
But it can be an attractive proposition for private clients. The long-term returns of private equity are consistently higher than those of traditional equities. Research from Datamonitor published in April found that in the 10-year period to 2003 European private equity yielded average returns of 13%, five points higher than from major stock indices.

Poor returns and heightened volatility from traditional equities over the past three years has seen growing demand for alternative asset classes including hedge funds, real estate and private equity. Analysts point to recent stock market volatility for the renewed emphasis on the need for diversification as well as returns.
So is demand growing in private equity markets? Wealth managers think so. PricewaterhouseCoopers found that while 45% of European wealth managers offered private equity products, 79% expected to do so within three years. Meanwhile, a survey from JP Morgan Private Bank gauging client perception about investment opportunities in the 10 new EU countries found that 40% of respondents thought private equity would be the best way to invest in central and eastern Europe.

So is it a safe bet? Datamonitor says private equity is not immune to wider equity market conditions. But the nature of the asset class creates opportunities for fund managers to exploit these for the benefit of the investor. When equity markets are down, private equity funds benefit because family businesses seeking capital have one less exit route since IPOs of businesses are less profitable, which allows fund managers to intervene.
But investing in private equity can be a game of craps. One Australian fund launched in 2000 offered investors an avenue into a venture capital fund that backed 20 start-up technologies companies, one of which was involved in the transmission of data across light beams – photonics as it is known in the sector. For investors unfamiliar with Star Trek the fund was a tough sell, its fund manager conceded.
Where family businesses are concerned, there are no ironclad guarantees for players in private equity markets. When years of poor profitability and ambitious expansion took its toll on Brio, the Swedish toy maker, the company considered issuing stock to a private equity fund. But bringing in a partner was seen as too expensive. One private equity investor that was approached said he declined because the toy industry was driven by the whims of the fashion and Brio relied on just one core product, according to reports.
There are success stories. Last June, Doughty Hanson & Co, the UK private equity house, agreed to acquire control of Europe's largest carpet maker, Balta Industries NV, in a deal valuing the group at €600m. The sale allowed the founding Balcaen family to diversify its wealth while still playing a role in the consolidation of the carpet industry. Doughty Hanson said it would take a 70% stake in Sint-Baafs-Vijve, Belgium-based Balta with Credit Suisse First Boston and Royal Bank of Scotland underwriting debt. The price equated to an enterprise value of 5.7 times Ebitda. The Balcaen family retained 20% and management the remainder. The Balcaens called the new structure a logical step in the development of a family business of its size. And with its new financial partner Balta can play a leading role in the consolidation process. "At the same time, the transaction is a step in diversifying the family capital," it said.

Diversification is a key focus and private equity plays a prominent role, especially for larger family businesses, according to McKinsey & Company. In a recent survey of 11 large family-owned businesses (seven had annual revenue exceeding US$10bn) the management consultant said all saw themselves as conglomerates, not as single business companies. All sought a mix between businesses with high risks and returns, and businesses that have more stable cash flows. Many of them had venture capital and private equity arms in which they invested 10-20% of their equity.

The idea, says McKinsey,  is to renew the portfolio constantly so the family holding can preserve a good mix of investments by shifting gradually away from mature growth sectors. When it came to diversification, asset-light businesses like retailing, consumer goods and trading were preferred to asset-heavy business like manufacturing "to avoid competition with public traded companies that have better access to capital".

Meanwhile, the proportion of wealthy clients investing in private equity varies widely across Europe. Based on interviews with 96 wealth managers, Datamonitor found that Spain had the highest proportion of wealthy clients (40%) investing in private equity. Families own approximately 65% of Spanish enterprises and a fifth of the largest 1,000 companies in Spain, which suggests that Spanish clients may be comfortable with investing in entrepreneurial ventures. In Germany and the UK only 10% of wealth managers' clients had exposure to the asset class.

But Europe needs to do more to attract private equity or investors will abandon it for emerging market economies elsewhere, according to a survey by the European Private Equity and Venture Capital Association. Jean-Bernard Schmidt, EVCA chairman, says Europe's governments must eliminate the legal complexity and reduce the steep administrative costs surrounding the asset class.  The survey was based on 13 indicators which the ECVA believes are key to a favourable private equity environment. These include fund structures, merger regulations, tax rates and incentives.

Despite this the market is gathering pace. After a quiet start to the year Europe's private equity market picked up in the second quarter, both in size of deals and frequency. The number of deals in the second quarter rose 5.8% to 110 with a total value up 11% to €1.7bn, according to the latest quarterly barometer of the industry published by Initiative Europe. At the same time the total value of European buyouts rose 44% in the quarter to €19bn. While deal activity increased in all sizes of buyouts, the growth in value was achieved at the higher end of the market. Buyouts in the €160m-1.65bn range generated almost 40% higher value than in the first quarter. Deals were mainly driven by corporate restructuring, followed by sales of family business and secondary buyouts.

Of late the complexion of the market has changed. The year began with a whimper due to the absence of any very large deals, according to European buyout fund Candover. But it could end with a bang. In European private equity overall, both the number and value of deals for the year to the end of June are well ahead of the equivalent 2003 period, Initiative Europe said.

Meanwhile, the market for private equity in Europe has plenty of scope for expansion. Fund managers believe that this expected growth will be spurred by the extent of family ownership of businesses, ongoing corporate restructuring and the privatisation of state-owned companies.  

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