Navigating the Private Equity Niches

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1 Callan Investments Institute May 2013 Research Navigating the Private Equity Niches A Guide to Specialty Private Equity Fund-of-Funds Investment Strategies Callan defines the pros and cons of nine niche strategies that might complement a core private equity program. Most niche fund-of-funds (FoF) strategies can be accessed through small boutique specialty firms, or specialty products offered by large private equity firms. For some strategies, the number of providers is limited and many lack proven track records. The appropriate allocation size to any particular niche product or strategy varies based on its risk profile, overall private equity market weighting, and role in the plan sponsor s portfolio. Callan encourages the application of a broad private equity strategy. Specialty vehicles may be complementary, but they are not for everyone. Each niche strategy targets a relatively narrow segment of the private equity marketplace and has a unique risk and return profile. Introduction As the private equity industry has developed, investors have become more experienced with the various strategies and regions that compose the private equity opportunity set. Along with that growing expertise, Callan has noticed an increasing preference by plan sponsors to be able to customize portfolios by dialingup or dialing-down commitments to various exposures, usually focusing on strategy type or geography. Most portfolio adjustments are undertaken to improve implementation, targeting either return enhancement or risk mitigation. Portfolio tailoring has predominately focused on harder-to-access niche strategies, which may have admittance constraints or be nascent, less populated, labor intensive, and costly. Examples of niche private equity FoF use might be: When a plan sponsor believes a strategy is under-represented, or lacks representation, in its broad core FoF, such as bolstering emerging markets or small buyouts. As an alternative to public market exposure, such as in the areas of real assets or private debt strategies. To modestly influence portfolio cash flow characteristics, such as employing secondaries or co-investments. Knowledge. Experience. Integrity.

2 Historically, customization has been accomplished mostly through the use of specialty managers that focus solely on niches in the private equity marketplace. Examples include: venture capital, small buyouts, secondaries, and regional products (e.g., Europe or Asia-only). Most niche products have been available for a long time (10 to 20 years, depending on the strategy), but recently the product and provider universes have expanded. Generally, these strategies have been accessed through commingled fund-of-funds (FoFs) offered by boutique investment managers. In response to plan sponsors desire for customization, we have seen a notable increase in large, broad-market FoFs separately offering various strategy pools within their one-stop products both to address the needs of their current clients and to appeal to a broader potential client base. As a firm, Callan encourages the application of a broad-market private equity strategy. 1 Specialty vehicles may be complementary, but they are not for everyone. Each niche strategy targets a relatively narrow segment of the private equity marketplace and has a unique risk and return profile. For a number of these strategies, the risks are readily identifiable; however, the returns will be more idiosyncratic and reliant on future market conditions, so conviction is imperative. They also commonly require the additional administration of smaller allocations. Focused Strategies Callan identified nine specialty product categories that might lend themselves to customization within, or be a complement to, a client s core program. We provide a brief description of each strategy, and the key benefits and challenges of each. This paper is intended only to provide a brief category description and a summary of the pros and cons of investing in each strategy type. Those interested in a particular type of investment should, prior to implementation, conduct in-depth analysis and due diligence. Most niche FoF strategies can be can be accessed through either small boutique specialty firms or specialty products provided by large private equity FoF firms. For some of these strategies, providers may be limited in number and/or lack proven track records. The appropriate allocation size to any particular niche product or strategy varies based on its risk profile, overall private equity market weighting, and role and anticipated impact in the plan sponsor s portfolio. The roster of strategies below is ordered in a theoretical, highly subjective, arguable ranking from lower risk to higher risk. Caveats regarding the order are: 1. To some degree, the strategies may not be directly comparable. 2. Implementation and quality of FoF manager is a critical consideration. To clarify, a lower-risk strategy that is poorly managed would be riskier than a well-managed higher risk strategy. 3. Each strategy has inherent risks to which investors may have varying tolerances. 4. The number of established providers with developed track records varies widely across categories. 1. Robertson, Gary. Private Equity After 25 Years: Background and Implementation. Callan, August

3 Nine Niche Product Types Secondary Funds Secondary funds focus on the purchase of private equity partnerships, as well as portfolios of private equity partnerships, that have completed their investment period and are beginning to distribute cash. Products typically target partnerships that are approximately 70% paid-in. The underlying portfolio companies are in place, and can be analyzed and re-priced based on their return prospects. The vehicles foster a faster asset build and early liquidity for investors, and are particularly appropriate for plan sponsors building new private equity portfolios. They can also help mitigate the J-curve for new programs. They have strong and relatively stable historical returns on both an IRR and multiple basis. These portfolios are very highly diversified, as most products approximate private equity market strategy-weightings, with an emphasis on buyouts for faster liquidity. They likely will not provide material exposure in non-core areas, although the strategy itself is non-core compared to primary partnership investing. Fees for secondary funds are higher than for FoFs (usually with a management fee of 1.00% to 1.75% and a carried interest of 10.0% to 12.5%). Fees at the underlying partnership level are lower, as the partnership commitment period has passed and fees are calculated on invested capital. Knowledge. Experience. Integrity. 3

4 U.S. Small Buyouts These FoFs invest exclusively in small corporate finance partnerships primarily buyouts with less than $1 billion in total commitments. Unlike broad-market FoFs, these provide specific coverage of the buyout market segment where partnerships are below $1 billion in commitments. They are particularly strong in the micro-cap segment where partnerships are below $500 million. The small company market is potentially less efficient and can present lower purchase price multiples. This area of the market has companies that have potential for substantial professional and operational improvement, which could translate into growth. These products tend to have relatively small capitalizations and very high fees (typically 1% fee on commitments and 5% carried interest). The high fee drag on small funds requires a relatively robust profit multiple before limited partner investors exceed break-even. Small companies have unique business risks (e.g., customer and supplier concentration) as well as fewer assets and financial reserves to weather economic downturns so the return profile can be volatile. They are similar to venture capital investments in this sense. Because successful small buyout partnerships typically raise larger amounts of capital in subsequent funds, the more successful general partners frequently exceed $1 billion by their third or fourth funds. equently, small buyout FoFs tend to be populated with more developing partnership managers that do not have proven track records or demonstrated organizational stability. Because of this, FoF manager due diligence has a larger element of qualitative assessment. 4

5 Co-Investment Co-investment funds make small, non-control investments in companies alongside a diverse mix of general partners. The products typically focus on buyout investments, although some products also include other strategies. Co-investment funds are more similar to direct private equity fund investments than FoF investments. Some FoFs include the ability to do co-investments within their mandate. Assets build at faster rates for new programs, since capital gets invested more quickly than with FoFs. It can help mitigate the J-curve by fostering distributions more quickly than FoF vehicles. It can help reduce fees, as the co-investment fees are less than direct partnerships and there is no FoF fee. Relatively few co-investment managers have developed track records. A number of co-investment track records were initiated in time frames near market tops, so interim returns may not be compelling. Co-investment managers have passive minority stakes, so they cannot influence exit timing. It provides exposure to an array of general partners investments in a single vehicle. Energy/Real Assets This strategy focuses on investments in partnerships in the natural resource and hard assets areas. Most products have a large energy component, particularly upstream oil and gas. They may also invest in products such as farmland, timber, mining, electric power, and infrastructure. Returns for the private equity oil and gas strategies have been very strong, and quite consistent, since funds began specializing in the sector. It provides a differentiated return source that may provide some cash flow and inflation hedging. It may not be considered private equity per se, if the managers invest outside the energy area (e.g., farmland, timber, infrastructure, or even real estate). There is a limited manager universe (about seven), and only two have mature track records.* Some of these types of FoF products have longer lives and less liquidity than private equity FoFs. This is because some may invest in partnerships with legal lives longer than 10 years, and hold assets for longer periods before exits begin. * As of May 2013 Knowledge. Experience. Integrity. 5

6 Venture Capital Venture capital FoFs focus exclusively on accessing high-quality, top-tier venture capital partnerships that are typically closed to new investors. They also focus on identifying newer partnerships that have the potential to become highly successful. Venture capital FoFs can be a conduit to firms that are otherwise inaccessible to new investors. These FoFs have long-standing relationships with some firms and conduct exhaustive campaigns with others to secure available limited partner slots for their products. This strategy can be used to tailor venture capital exposure, usually by tilting exposure to earlier-stage funds. Similar to small buyouts, high fee drag at the FoF vehicle level can be challenging. Venture capital has underperformed buyouts since the tech bubble, so conviction is needed to invest in a specialty venture product or to increase total private equity portfolio exposure to venture capital above 25% to 30%. Specialists with strong reference networks in the venture industry can increase the chance of selecting advantaged partnerships. Venture capital partnerships can otherwise be difficult to evaluate during due diligence because the analysis is more qualitative than quantitative. Debt-Related Funds These FoFs invest in mezzanine or distressed debt and restructuring equity partnerships and sometimes combine the various strategies. Some may include a small allocation to private senior debt partnerships. Most broad-market FoFs have very selective or partial coverage of private debt strategies. Private debt-oriented strategies theoretically have a lower return and risk profile because they focus on investing higher in company capital structures, although implementation risk can be significant. They are defensive and tend to do well in recessionary periods when equity strategies such as venture and buyouts are challenged. They may provide a modest current yield. There are few debt-related FoF providers, and most focus on a single debt strategy (mezzanine or distressed), not multiple debt strategies. Timing of implementation can have a strong influence on results, as debt strategies are more tactically sensitive than others. Products may include hedge fund strategies as well as private equity-oriented funds. Niche FoF fees can be high relative to the debtrelated strategies return potential. 6

7 Europe Small Buyouts Similar to U.S. small buyouts, these FoFs focus on country-specific or small niche funds in Western Europe. Most broad-market FoFs emphasize larger funds with Pan-European strategies. These niche products specialize in the small- and micro-cap segments that are country- or regionspecific. This strategy provides many of the same company improvement and market inefficiency benefits previously mentioned for small U.S. markets. Europe currently presents a potentially risky investment landscape due to sovereign and banking concerns. These may impact small businesses, as well as regional economic growth prospects in general. Europe has been significantly less liquid for small companies than the U.S. market. Asia and Emerging Markets These FoFs target partnerships that invest mainly in emerging market countries, with most products strongly emphasizing China and India. Some broad-market FoFs are slower to address nascent emerging market opportunities. On a capitalization basis, Asia and emerging markets represent approximately 10% of the private equity market based on capital commitments. Emerging countries exhibit higher GDP growth rates than developed countries. This strategy poses risks similar to public emerging markets investments, including currency volatility/devaluation risk, political risk, and rule-of-law risk. In addition, the majority of investment opportunities are non-control growth equity placements, which increases exit risk. It has a large reliance on volatile and less developed public markets for exits. Investment track records tend to be binary (i.e., both large losses and large gains in the underlying companies and partnerships, as opposed to consistent returns), and relatively few general partners have mature track records. Knowledge. Experience. Integrity. 7

8 Clean Tech These FoFs target partnerships that are primarily pursuing clean energy-related strategies. These may include infrastructure-related projects such as wind farms, solar farms, ethanol plants, and biomass (waste) plants, as well as technology companies such as battery development, solar panel development, and utility software. These investments target an emerging industry where companies may have strong growth potential. The strategy may be considered a sociallytargeted (Environmental, Social and Governance, or ESG ) investment. There are only about three FoF providers of this strategy, and none of the products have mature track records.* Many clean energy projects rely on government support. U.S. incentives and subsidies have tended to focus on the short term, whereas these investments are longer-term. Conclusion For certain investors, a case can be made for the ability to tailor commitment exposures. Portfolio adjustments through emphasizing (or deemphasizing) niche private equity investment strategies may add diversification to potentially hedge against volatile markets, or to target sectors perceived to have attractive long-term return characteristics. These niche strategies have various objectives and degrees of risk, and may be used in combination with the investor s primary private equity portfolio. In some instances, investors may seek out a dedicated, specialized investment manager. Others may be able to adjust various weightings, or select specific pools within the core products of broad-market FoF providers. Regardless of the strategy and the implementation, investors should thoroughly evaluate the risks and rewards of any additional investment strategy and clearly define its purpose within the overall investment program. * As of May

9 Author Gary Robertson Gary Robertson is a senior vice president and Manager of Callan s Private Equity Research group. Gary is responsible for the firm s Alternative Investments consulting services. He is currently secretary of Callan s Client Policy Review Committee. If you have any questions or comments, please About Callan Associates Founded in 1973, Callan Associates Inc. is one of the largest independently owned investment consulting firms in the country. Headquartered in San Francisco, California, the firm provides research, education, decision support, and advice to a broad array of institutional investors through four distinct lines of business: Fund Sponsor ulting, Independent Adviser Group, Institutional ulting Group, and the Trust Advisory Group. Callan employs more than 170 people and maintains four regional offices located in Denver, Chicago, Atlanta, and Summit, N.J. For more information, visit About the Callan Investments Institute The Callan Investments Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry Callan Associates Inc. Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Investments Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. Knowledge. Experience. Integrity. 9

10 Corporate Headquarters Regional Offices Callan Associates 101 California Street Suite 3500 San Francisco, CA Atlanta Chicago Denver New Jersey

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