Recent publicity surrounding high profile private equity bids for companies like Qantas, Myer, Coles and PBL has put private equity under the spotlight.
With the takeover activity around these iconic businesses, concerns have arisen around the ‘public interest’ and the debt levels being proposed. These issues remain largely a function of the mega deals, rather than the core of the industry. Nonetheless, it is a concern that investors may misunderstand the role of private equity in the market as a consequence.
In the last decade, private equity has developed as a dynamic asset class that contributes positively to productivity and business innovation in Australia. It can also provide a valuable investment opportunity for investors of all sizes.
The state of the market
Currently, over $22.4 billion is invested in private equity assets, and the average fund size is now $414 million, compared with $74 million five years ago.
This growth in private equity has largely been boosted by Australia’s burgeoning retirement pool, coupled with superannuation fund trustees’ increasing search for higher returns and investment portfolio diversification.
Despite this growth, private equity only represents 2 per cent of assets managed by the investment industry. However, this is expected to increase over time, spearheaded by large superannuation funds, which now allocate, on average, around 5 per cent to this asset class. We also expect to see greater access for retail investors as listed investment companies (LIC) and fund of funds structures become more widespread.
Current misconceptions
Private equity managers have a short-term focus
This statement loses traction when you consider that private equity managers usually become shareholders of the company to assist its expansion, improve operations and create a platform for sustained growth. The ultimate aim is to create a highly desirable enterprise that attracts a premium price when sold to other parties, which may (or may not) include listing on the Australian Stock Exchange (ASX).
Historically, a later stage private equity manager would generally plan to hold on to an investment for about five years. The holding period for venture capital investments would generally be longer, as start-up businesses need to prove themselves.
Because assets are held in what are known as closed-end vehicles, a manager must ensure all assets are realised once a fund reaches the end of its life (usually 10 years). However, this does not mean the private equity manager will not take advantage of opportunities to sell in shorter timeframes if the price is right.
Overseas investors are gaining the lion’s share of the Australian private equity market
Offshore investors are increasingly seen in the domestic press, but have yet to win many significant deals outside the media arena. They are only interested in very large dollar deals and not in the smaller transactions that dominate the sector by number. The private equity industry has always operated in a highly competitive bidding environment, but there is no evidence of a shortage of deals in Australia. In the 2006 fiscal year, 97 deals (plus 77 follow-on investments) totalling $2.25 billion were completed in the market.
Private equity bids for listed companies are creating an unstable share market
Public take-overs happen all the time. The only recent change has been more high profile activity involving private equity players. Public to private transactions like Qantas will generate greater media scrutiny because of their size and stature in the market. However, the most common form of private equity investment is private-to-private transactions.
Private-to-private transactions often involve small to mid-sized companies that are less well-known and, therefore, do not get much media attention. Let’s not forget that private equity is a development ground for many companies that eventually list on the stock exchange. In 2006, $8 billion was raised by initial public offers (IPO). In contrast, of the 78 companies de-listed from the ASX, only two were as a result of a private equity transaction.
Debt levels in deals have increased to dangerous levels, increasing the chance of corporate failure and a strain on Australia’s financial system
A management buyout or leveraged buyout (LBO) is financing using a combination of equity and debt. According to a study by the Reserve Bank ofAustralia (RBA), debt financing in recent LBO transactions has been around 70 per cent of the funding. Institutional investors have typically provided the subordinated debt in the transactions, whereas banks have typically accounted for the (less risky) senior debt.
Over the last year there were $26 billion worth of planned or completed LBOs, compared with $2 billion for the previous five years. On closer examination, these deals were concentrated on a few companies, with the planned buyout of Qantas totalling $11 billion, and the debt does not come from just Australia. A survey by the Australian Prudential Regulation Authority has revealed that of 20 recent private equity deals, about two-thirds of the participating banks were from offshore.
Experienced private equity managers understand leverage can be a powerful financial tool. However, they are also aware that debt structures need to be tailored to suit the circumstances of a company and that leveraging can increase financial risks. The lenders (major banks) are also acutely aware of this. As far as a strain on Australia’s financial system, the RBA has commented that corporate gearing on an aggregate level (across all Australian companies) is relatively low currently.
The case for private equity as an investment
Whilst a relatively new concept for many investors, private equity has existed in various forms for hundreds of years — after all, it’s merely investment into a private business.
More recently, it has developed from discrete, opportunistic investments by financial institutions into a standalone asset class, accessible through a variety of structures. Similarly, the investor base has expanded from corporates and large superannuation funds to smaller funds and retail investors.
The depth of understanding and appreciation will improve in time as investors become more familiar with the unique structures, management skills and financial instruments that are all part of the ‘private equity package’. It will continue to attract attention as investors explore different ways to increase their investment returns, and this asset class can deliver, as it exploits the information inefficiencies inherent in private companies. Private equity will enhance a portfolio through higher returns and greater diversification.
The high returns that private equity can deliver are shown in Table 1. Mature investments have clearly performed the best in the market. However, venture capital has proved more challenging, given that these investments are generally more volatile.
Private equity is designed as a win-win proposition for all involved. For the investor, it can provide a return premium well above listed equities. For the company, it provides a reliable means to grow and prosper. For the private equity firm, it allows it to extract financial benefits by being aligned to the success of the company.
A private investment does not come without its requisite risks, however, through experienced private equity teams and greater industry participation private equity can establish its position as an important investment option within a diversified investment portfolio.
Jon Schahinger is director of private equity at ING Investment Management and the managing director of the publicly listed private equity company, ING PrivateEquity Access .
