An introduction to private equity

Transcription

1 An introduction to private equity Pictet Alternative Advisors SA 2014 Private equity funds have earned a reputation for generating returns above those of public equity markets. A prudent selection offers diversified exposure to attractive sources of risk premiums over the long term. Private Equity in perspective Page 5 The purchase of private companies has been practiced since the Industrial Revolution. Investing in Private Equity Page 9 Private equity returns surpass those of public equity markets, and top quartile funds usually generate consistently strong multiples on invested capital. Pictet a strategic partner for Private Equity Page 15 Founded in 1805 in Geneva, Pictet is a leading asset manager in Europe for both private and institutional investors.

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3 Contents Page 4 Executive summary 5 PART I Private equity in perspective The beginnings of private equity Definition of private equity How does a private equity fund work? The private equity industry today Private equity strategies Private equity investments 9 PART II Investing in private equity The case for private equity Private equity performance and valuation measures Investor concerns Private equity fund of funds model 15 PART III Pictet a strategic partner for Private Equity Pictet Group Pictet Alternative Advisors SA Investment philosophy Pictet s private equity value proposition Manager selection Reporting 17 Glossary and useful terms 3

4 Executive summary Private equity funds have earned a reputation for generating returns above those of public equity markets. A prudent selection offers diversified exposure to attractive sources of risk premiums over the long term. Understanding the capital growth drivers of private equity strategies and sourcing leading managers remains crucial to constructing a long-term investment programme for private equity investors. Opportunities exist throughout a company s life cycle, but each stage calls for particular skills in order to unlock a company s growth potential. Only some private equity managers have the right tools at their disposal to consistently meet their investors expectations. At Pictet Alternative Advisors SA, we have been using our extensive know-how in alternative investments to select top quartile private equity funds for high net worth and institutional clients since the 1980s. Our private equity team ensures that the results of its selection meet the requirements of our clients and address the opportunities in any given economic environment. The team has maintained strong relationships with key industry players. Strengthening long-term partnerships with prominent private equity managers has been instrumental to our success in managing segregated and commingled private equity portfolios for our clients. 4 An introduction to private equity

5 PART I Private equity in perspective The beginnings of private equity The purchase of private companies has been practiced since the Industrial Revolution, however it is broadly accepted that the first true buyout was J.P Morgan & Co s purchase of Carnegie Steel Company from Andrew Carnegie and Henry Phipps for $480 million in Prior to the second World War, most private equity investments were orchestrated by large families and very wealthy investors welcomed the first two venture capital firms: American Research and Development Corporation (ARDC) and J.H. Whitney & Company. The latter is credited with the first successful venture capital deal as in 1957 it invested USD 70,000 in Digital Equipment Corporation, which would later be valued at USD 335 million following its initial public offering (IPO). Definition of private equity Private equity capital is equity capital that is not quoted on a public exchange. Private equity investors or funds make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors and can be used to fund start-ups (venture capital), make acquisitions (growth equity, buyout), or to strengthen a balance sheet (special situations). Such investments are commonly made by private equity firms, venture capital firms or "angel investors". Investments are generally made through a fund partnership having the following characteristics: Private equity funds are closed-end investment structures A fund s terms and conditions are defined in a limited partnership agreement The term of a fund ranges between 10 and 12 years Investment disciplines include leveraged buyouts (LBO), venture capital, distressed, growth, mezzanine finance and angel investor. How does a private equity fund work? The fund s manager, or general partner, establishes a limited partnership agreement that sets forth the terms and conditions governing investment in the fund. Investors in the fund, or limited partners, fund capital calls up to their agreed commitment level for the duration of the investment period (4-6 years). Once a portfolio investment is realised i.e. the underlying company is sold to a financial buyer, a strategic investor or gone public via an IPO the fund distributes proceeds back to the limited partners. Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 5

6 The private equity industry today The private equity industry has enjoyed significant growth since the 1970s. At the end of 2011, assets under management - the sum of dry powder and the net asset value (NAV) of private equity investments - totalled USD 3 trillion according to the private equity research firm Preqin. Trends in fundraising and the number of funds demonstrate the industry s cyclicality and the indirect impact of credit cycles in debt markets on entry and exit multiples. As a result, the industry has gone through a process of consolidation, and the number of funds has fallen from its 2000 peak of 1,923 funds to 1,029 in Traditionally, family offices and university endowments were the main allocators to private equity. However, the risk/return profile of private equity investments has recently attracted non-traditional investors such as sovereign wealth funds. YEARLY FUNDRAISING SINCE ' '000 Number of funds (LHS) Amount raised in date in USD bn (RHS) 1' '500 1'418 1'384 1'245 1'192 1'249 1'164 1'271 1' ' ' ' Source: ThomsonOne, data as at Private equity strategies Private equity funds typically employ a transformational, value-added, active investment strategy. However, diverse investment strategies can be used depending on where the company is in its life cycle. Each stage of a company s life cycle exhibits a certain risk profile and requires a specific set of skills from the general partner. There are three principal financing stages in a company s life cycle. Venture capital Venture capital refers to investments made in young companies with no or limited revenues. This stage emphasises entrepreneurial undertakings and focuses on less mature businesses and industries. As the efficiency of a technology, concept or product has yet to be proven, venture capitalists are ready to accept a potential risk of failure of the companies in their portfolios. Returns are relatively binary. An unsuccessful investment can lead to a total loss, while a successful outcome can yield a very high return on investment. Usually, one to two transactions, considered home runs, drive the performance of the entire fund, while the rest of the portfolio lags. 6 An introduction to private equity

7 Growth capital Growth capital refers to equity investments, most frequently minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business. Buyout Buyout investments consist in acquiring a stake in a private company (non-listed or public to be taken private) with the intention to exercise influence on the company. Buyout funds usually invest in mature, established companies with a strong market position. The buyout manager draws up, together with the company s management, a business plan to develop the company further, either organically and/or by applying a "buy and build" strategy. This process consists of acquiring a company of a significant size, and then adding smaller companies to the initial acquisition in order to create a significant player in the industry. Buyout managers will support the company's management in its acquisition plan, negotiating possible debt financing and efficiently consolidating the business. The plan may also include some cost restructuring measures, the disposal of non core assets or the sale of unprofitable divisions. Buyout transactions make sense when buyout capitalists believe they can extract value by holding and managing a company for a period of time and exiting it after significant value has been created. Buyout investments can be further classified into small-, mid- and largecap transactions according to the value of the targeted company. Generally buyout transactions are leveraged, i.e. partly financed with a certain amount of debt in addition to equity. Special situations Special situations funds invest in restructuring, turnaround, distressed debt for control and any other unusual circumstances that a company can face. This category includes investments in equity and equityrelated instruments as well as debt instruments. Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 7

8 Private equity investments Three types of private equity investments are possible. Primary investments Primary investments, or primaries, are investments in newly created closedend private equity partnerships. After conducting a due diligence on the general partner, its strategy and track record, limited partners commit an amount to the new fund. However, at the time of commitment, limited partners have little visibility on the underlying investments that will be made by the fund. Capital is called as investment opportunities arise. The general partner will call and deploy the funds during the typical four to six years investment period. Co-investments A co-investment is a direct investment by the limited partner in a company alongside a private equity fund. This occurs when general partners want to acquire a stake in a company larger than the one allowed by the diversification requirements laid down in the limited partnership agreement. Consequently, general partners will syndicate part of their exposure to this single company by offering it to a handful of existing limited partners. Co-investments allow the limited partner to increase his exposure to a particular opportunity through both the fund and direct investment. Co-investments are very often offered on a no-fee, no-carry basis. Secondary investments Secondary investments, or secondaries, are existing limited partner private equity interests available on the secondary market. Secondary investors enjoy shorter investment periods and accelerated returns on invested capital. As secondaries are composed of existing assets, which means the fund has already deployed the majority of its capital to portfolio companies, the risk associated with investing in a blind pool of assets is reduced. Furthermore, write-offs and losses which may occur in the early years of a private equity investment can be avoided when acquiring a fund at a later stage of its life. 8 An introduction to private equity

9 PART II Investing in private equity The case for private equity Attractive returns: Over the past three decades, private equity investments have demonstrated attractive risk/return characteristics. Returns surpass those of public equity markets, and top quartile funds usually generate consistently strong multiples on invested capital. This premium return over public markets is required to compensate investors for the longterm nature of such investments. With an investment horizon of more than 10 years, there is an illiquidity premium for investors prepared to accept a lower level of liquidity. The use of financial leverage in private equity investments further bolsters returns. But leverage risk must be managed. Thanks to extensive due diligence that general partners perform on target companies, they are able to establish an information edge supporting their decision to invest. PERFORMANCE BY VINTAGE (%IRR) 30.0% 27.7% 25.0% 22.7% 24.5% 24.0% 20.0% 15.0% 10.0% 11.0% 16.0% 9.6% 15.6% 12.3% 10.6% 8.7% 9.1% 10.9% 9.6% 14.3% 16.6% 16.0% 12.3% 9.2% 8.3% 8.7% 5.0% 6.9% 6.0% 4.8% 5.0% 5.6% 3.1% 2.9% 6.3% 5.0% 0.0% Private Equity 1st quartile Private Equity Median MSCI ACWI (all country world index) Source: ThomsonOne, Pictet Alternative Advisors SA, data as at Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 9

10 Value creation over the long term: Private equity general partners aim to create operational value in companies through active involvement and strategic orientation. Over the long term, operational value can be generated by developing the business plan, selecting and strengthening the management team, accessing new markets, pursuing growth strategies by accretive acquisitions, etc. Private equity is a good source of long-term equity capital compared to public markets. The pressures of daily stock volatility, analyst estimates, shareholder lawsuits, regulations (Sarbanes-Oxley, for example) and other factors have made public companies overly focused on the short term. Private equity capital can allow companies to take a longer-term view in terms of executing on strategy and restructurings. Private equity investments enable investors to capture the illiquidity premia and to access the intrinsic value generated by a private equity fund. Research by Pictet demonstrates the benefits of a private equity allocation in a global portfolio. Indeed, an annual commitment of 5% in private equity improves the portfolio s overall performance and efficiency by reducing its volatility. Market resilience: Private equity offers valuable resilience against market cycles. Historical data show that each vintage generated positive performance over the last 20 years. Moreover, funds launched during market meltdowns outperformed as they were able to take advantage of low valuation periods. Portfolio diversification: Including private equity in a balanced portfolio can improve its overall diversification. Private equity returns have demonstrated a low correlation to public equity and bond markets. PRIVATE EQUITY MEDIAN NET IRR BY VINTAGE YEAR 20 in % 18 Median IRR during meltdown years Net IRR Source: ThomsonOne, data as at An introduction to private equity

11 Private equity performance and valuation measures Measuring the performance of illiquid investments is not as straightforward as measuring that of traditional asset classes. Timing the cash flow pattern of a private equity fund leads to what is commonly known as the J-Curve effect. The unpredictability of capital deployment when opportunities arise and of distributions when transactions are realised make it difficult to calculate time-weighted returns. As such, the Internal Rate of Return (IRR) and investments multiples are the two measures used to assess the performance of private equity investments. The J-Curve effect: The J-Curve is the name given to the line, shaped as a J, representing the cumulated net cash flows of a private equity fund during its life. The early years of a private equity fund are characterised by negative cash flows, and therefore negative returns, due to the capital calls, the management fees and the cost of investments. As an illustration, the chart below shows that this particular fund does not return any capital until year 3, whereas capital is called in the meantime. Once the fund starts to exit the early deals, distributions are made to investors. Consequently, the net cash flows of the fund break even in year 7 and become positive. ILLUSTRATION: THE J-CURVE EFFECT OF THE NET CASH FLOWS USD million Commitment Capital Calls Distributions Net Cash Flows (cum.) Year 1 7 years to breakeven Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Source: Pictet Alternative Advisors SA Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 11

12 Internal rate of return (IRR): The IRR is the standard performance measure for private equity investments. It is particularly suitable for assessing private equity investments because it captures the timing effect of cash flows. The IRR is the discount rate that makes the net present value of all cash flows equal to zero. Investment multiples: Investment multiples are complementary measures to the IRR. They express the value of the investment returned to a limited partner as a multiple of its cost basis. However, they do not take into account the timing of cash flows. There are two commonly used multiples: a. Total value to paid-in (TVPI) ratio represents the fund s total value as a multiple of its cost basis. TVPI is calculated by dividing the realised amount added to the net asset value of unrealised investments by the investment cost. Private equity performance is best measured using IRR combined with investment multiples. Taken together, the two measures reflect the performance and allow for timing considerations. Net asset value Finally, the net asset value (NAV) is used to value private equity funds. Since private equity investments are not listed, the NAV relies on estimates made by general partners, who re-evaluate the underlying assets periodically. Methods used in this process encompass discounted cash flows, comparable transactions and public market multiples. The NAV is often referred to as a fund's residual value, as it represents the value of all investments remaining in the portfolio. This is a bottomup technique in which individual companies are valued and then aggregated to compute the private equity fund value. b. Distributed to paid-in (DPI) ratio is calculated by dividing the cumulative distributions by the capital called. It gives a private equity investor an indication of distributions relative to capital paid into the fund (capital called). If the DPI is greater than one, then the investor has broken even. It is a performance measure net of management fees and carry. 12 An introduction to private equity

13 Investor concerns Private equity is often considered a highly secretive industry operating under the radar screens of regulators, open only to a few ultra high net worth investors. Misconceptions about private equity arise from its risky and complex nature. Investors often regard private equity as a win or lose bet but one that also offers great potential returns. Myth and reality We list some of the most recurrent myths and explain why, in our view, these are actually mistaken beliefs. MYTH Private equity firms don't add value because they haven't been in an operating role. Private equity firms win while entrepreneurs lose. Private takeovers are often blamed for the loss of jobs through factory closings or other restructuring moves. Private equity funds are vultures only focused on short-term profits. REALITY Private equity firms can add value by challenging management to think outside the box. Private equity firms can recognise patterns that may not be obvious to management teams and possess a network of relationships that can assist companies in recruiting talent at the board and management level. They can often help companies explore strategic partnerships with other firms. Nowadays, most private equity firms have operating capabilities at the firm. An entrepreneur typically retains substantial interest in the business. Private equity firms only make money if the value of the company appreciates. It is in the best interests of private equity firms to help the company grow and increase its value. A private equity investment provides entrepreneurs with the opportunity to diversify their assets. Industries where private equity funds have been active grow more rapidly than other sectors, whether measured using total production, value added, total wages or employment. First, private equity funds represent a potential governance role model for the next-generation businesses. Second, they can be a potent partner for companies seeking to expand overseas. They have very deep experience in acquiring companies, putting in new 'world-class' management teams and turning them around. Lastly, companies can tap into the management s know-how and experience of global private equity funds. Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 13

14 Private equity fund of funds model Within a balanced portfolio of assets, including private equity has demonstrated an improved risk/ return profile by diversifying the asset mix. Allocating to the asset class via a dedicated private equity fund of funds diversifies exposure across geographic regions, types of investment (primary, secondary, co-investments) and financing stages (venture, growth, buyout and special situations). Idiosyncratic risks inherent to investing in a single manager or a handful of funds are reduced through a fund of funds. Likewise, deploying capital across multiple vintage years diversifies the risk of being concentrated in one vintage or deploying capital at the market peak. Fund of funds specifically offer investors the opportunity to directly leverage long-term relationships with top quartile general partners demonstrating consistently strong returns. 14 An introduction to private equity

15 PART III Pictet a strategic partner for private equity Pictet Group Founded in 1805 in Geneva, Pictet is a leading asset manager in Europe for both private and institutional investors. As at March 2014, assets under management and in custody totalled around USD 447 billion (CHF 394 billion; EUR 324 billion). Pictet Group employs more than 3,500 people worldwide, including 900 investment professionals, analysts, economists and strategists. Pictet Alternative Advisors SA Pictet Alternative Advisors SA is the division of the Pictet Group responsible for investments in hedge funds, private equity funds and real estate funds. Established in 1991, it constructs, manages and advises on portfolios of alternative investment solutions for institutional and private clients. The division consists of around 45 employees and manages over USD 14.5 billion. Investment philosophy Over the years, Pictet Alternative Advisor SA has developed investment principles and rules based on best industry practice and solid experience, which today lie at the heart of our investment philosophy. This latter relies on four pillars: Intrinsic value creation: We identify private equity managers that focus on building the intrinsic value of the companies they own through strategies and restructurings focused on growing revenues and improving margins. Long-term relationships: We seek partnership-like relationships with the funds in which we invest. This long-term perspective gives us access to the world s top private equity funds and subsequent generation. Human capital: We recognise the significance of investing in managers who demonstrate established and cohesive teams with a disciplined dedicated approach to their private equity investments. Furthermore, we value clear alignments of interests within the management structure and with firms that share Pictet s values. Bottom-up: Bottom-up selection relies on investing in managers that demonstrate consistent absolute performance backed by proven track records. Unlike many market participants, we do not feel compelled to allocate to all strategies and regions. Historically, we have avoided underperforming sub-classes such as venture capital, low yielding assets like infrastructure, or areas that depend on financial engineering. Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity 15

16 Pictet s private equity value proposition Pictet s private equity fund of funds expertise is based on its longstanding experience in managing discretionary portfolios of private equity funds and co-investments. The team follows a global diversified buyout strategy and selects only top quartile performers with proven and deep track records, funds that have been long-term equity investors and that demonstrate significant control and influence on their underlying investments. Our aim is to provide investors with a global exposure to private equity that achieves long term premium returns over public equity markets. Each programme has an emphasis on managers who deliver returns based on operational improvements rather than through financial engineering. When investing in private equity, statistics show a crucial pattern in fund returns. Past and future fund performances tend to be highly correlated in private equity. This suggests that there is a likelihood that the next funds managed by the general partner will remain in the same performance bracket. This feature gives a substantial advantage to investors, such as Pictet Alternative Advisors SA, that have been investing in the asset class for a long time and that have gained privileged access to top tier private equity managers. Manager selection In its manager selection, Pictet Alternative Advisors SA targets private equity managers who exhibit exceptional skills in their field of expertise. We follow a strict analytical approach to investing in private equity, based on robust analysis and risk management processes. Potential funds are subject to a rigorous, standardised and documented evaluation process before any investment is made to ensure that only funds meeting our strict investment criteria are selected. Reporting Pictet Alternative Advisors SA Private Equity heavily relies on its operations team for the execution of its investment recommendations as well as to ensure the monitoring of investments through our proprietary reporting system called PiPER (Pictet Private Equity Reporting). PiPER is a vital tool that allows the team to measure and report the performance of complex private equity portfolios to clients. In addition, the team publishes a quarterly product report highlighting the major events in each private equity strategy, including a comment on the performances posted by all the underlying private equity funds. 16 An introduction to private equity

17 Glossary and useful terms Capital call The amount of funds from the commitment that is called up by the PE fund for making investments (and paying the fund fees). Commitment The maximum amount an investor will be required to invest. On average funds typically draw approximately 90% of the committed amount within the first four to six years of a fund. Distributions are expected before the full amount of the commitment is called. Distributed to paid-in (DPI) multiple Distributions received to date as a % of the called up capital. Distribution Capital distributed to a fund's investor as underlying investments are realised. Usually, an investor will receive his/her initial investment plus a preferred return before the general partner can participate in the profits. Such arrangements are specified in the Limited Partnership Agreement and are referred to as "distribution waterfall". General partner The fund manager. Internal rate of return (IRR %) The annual compounded rate of return of the investments in the fund. Net IRR is earned by investors net of fees and carry. Invested capital The amount of the commitment that has actually been invested in underlying companies. Limited partner The investor in the fund. Net asset value (NAV) The value of the investments based on the private equity firm s valuation guidelines. This value is rarely correlated to the commitment amount. By itself, the NAV is not an indicator of fund performance as it does not reflect levels of capital calls and disbursements. Residual value paid-in (RVPI) multiple The valuation of unrealised investments as a percentage of called capital. Quartile The 25% bracket into which a fund s relevant peer group falls. The top (or first ) quartile refers to the top 25%. Total value to paid-in (TVPI) multiple Distributions received to date and unrealised value as a % of the called up capital. Vintage The first year in which a commitment is made. As the fund invests over several years, this simply indicates the starting point of the investment period. 17

18 Disclaimer This document is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. In particular, investment funds or any other collective placement instruments which have not been authorised for public offering in the investor s country of domicile may only be offered as private placements to qualified investors. Additional investment restrictions may be provided for in the official offering documentation (available upon request). The information and data furnished in this document are disclosed for information purposes only; the Pictet Group is not liable for them nor do they constitute an offer, an invitation to buy, sell or subscribe to securities or other financial instruments. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. Information and opinions presented in this document have been obtained from sources believed to be reliable, and, although all reasonable care has been taken, the Pictet Group is not able to make any representation as to its accuracy or completeness. The value and income of the securities or financial instruments mentioned in this document are based on rates from the customary sources of financial information and may fluctuate. The market value may vary on the basis of economic, financial or political changes, the remaining term, market conditions, the volatility and solvency of the issuer or the benchmark issuer. Moreover, exchange rates may have a positive or negative effect on the value, the price or the income of the securities or the related investments mentioned in this document. Past performance must not be considered an indicator or guarantee of future performance, and the addressees of this document are fully responsible for any investments they make. No express or implied warranty is given as to future performance. Investors shall conduct their own analysis of the risks (including any legal, regulatory, tax or other consequence) associated with an investment and should seek independent professional advice. The content of this document is confidential and can only be read and/or used by its addressee. The Pictet Group is not liable for the use, transmission or exploitation of the content of this document. Therefore, any form of reproduction, copying, disclosure, modification and/or publication of the content is under the sole liability of the addressee of this document, and no liability whatsoever will be incurred by the Pictet Group. The addressee of this document agrees to comply with the applicable laws and regulations in the jurisdictions where they use the information reproduced in this document. This document is issued by the Pictet Group. This publication and its content may be cited provided that the source is indicated. All rights reserved. Copyright Private equity in perspectives Investing in private equity Pictet a strategic partner for private equity Pictet's private equity solutions 18

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