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Private Equity Beckons - Eureka Report Article

January 29, 2007
Private equity beckons
By Scott Francis
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PORTFOLIO POINT: Now they are trading on the ASX, private equity funds are more accessible and don't lock your money up for a decade. But they should be considered long-term.

Until very recently private equity investment, particularly for smaller investors, has been about investing in smaller companies that are not listed, with a view to listing them on a stock exchange at a profit in the future. But in the past year or so private equity transactions more commonly refer to the acquisition of publicly listed companies with a view to "taking them back into private hands". The Qantas deal where Macquarie Bank is financing a privatisation of the airline is typical of these new deals.

Recent examples of the more "traditional" private equity transactions would include Pacific Brands and Repco. Both of these were sold from the former conglomerate Pacific Dunlop in 2001. The two companies were bought by private equity companies and were both successfully relisted less than three years later at significant profit to the private equity groups involved.

There are two primary options for private investors in the local private equity market: closed-end managed funds; and private equity listed investment companies.

Closed-end managed funds

Private equity funds are growing in popularity. They differ from most managed funds in that they are seriously long-term; it can be expensive, if not impossible, to remove your money in a short time frame and the funds have high minimum entry amounts.

These private equity-focused managed funds allow investors to buy a number of units in the fund, not unlike a traditional managed fund. Often only part of the payment is required up-front, with instalments then paid over time as the fund makes private equity investments. Generally the minimum investment is in the order of $20,000-50,000.

Unlike a managed fund, there is no ability to redeem investments on a regular basis; usually investor funds are tied up until the fund is wound up five or 10 years down the track. This is a significant factor that investors must be aware of: these managed funds are usually illiquid, investors must be sure that the money they invest in them is not going to be needed for up to 10 years.

The fees on this style of managed fund are higher than an average retail managed fund, although it is reasonable to assume that there is significantly more work to be done in putting together a portfolio of unlisted companies than in putting together a portfolio of listed companies with their more transparent trading and reporting histories.

The Millhouse IAG Private Equity Fund (an international fund marketed to Australian investors) shows the higher level of fees that private equity investors face. The fees for this fund include: an issuer fee of 1.2%, an expense recovery fee of 0.5%, and a management fee of 2% of gross assets. That is a total fee of 3.7%, about twice the rate of an average managed fund.

A successful example of a closed-end managed fund is the Gresham Private Equity Fund No. 1. This fund was involved in the purchase of Repco from Pacific Brands, and its successful sale about two years later. It was established in 1999 with $200 million of committed capital, about half of which came from Wesfarmers.

As at June 2006 it had "called" (received from investors) $160 million of that capital, distributed $322 million back to investors from successful private equity sales and still had three investments yet to be sold. This is a particularly successful venture. Gresham launched a second Private Equity Fund in 2004, which has made a number of purchases but is yet to sell any of its investments.

Colonial First State has a Diversified Private Equity Fund, which it started in 2001. It has received $103 million from investors. It had, up until June 2006, returned to investors distributions of $71.7 million, with cash and investments valued at $69 million still held in the fund.

A more recent fund was the Macquarie Co Investment Fund, launched in May 2005, which is a private equity fund with a 10-year timeframe and a $20,000 minimum investment for investors, payable in two instalments.

Private equity funds have three important characteristics:
  • They are illiquid: once you invest you are in for the full time frame of the fund (likely to be around 10 years).
  • They have relatively high fees.
  • They require relatively high minimum investments (often $20,000-50,000).

The other problem for investors is that these funds are only open for short periods of time, during which capital is raised for the fund. The fund is then closed. So, if you want to invest in a closed-end private equity fund, you need to be aware of the opportunities when they come up.

Listed investment companies

Listed investment companies are most often described as managed funds that trade on the ASX: a broad-brush description that serves us pretty well in this situation. Because listed investment companies trade on the stock exchange, they provide the solution to the fact that closed-end managed funds tend to be illiquid and have relatively large minimum investment levels.

Being listed on the ASX, private equity listed investment companies can be bought and sold any time there are willing buyers and sellers, and can be bought in small parcels.

In contrast to the high fees faced in the managed fund markets, investors in private equity style LICs need only pay basic stockbroking fees; moreover, the minimum entry levels can be as low as a few thousand dollars because the only restriction is that investors buy a minimum block —500 shares — in the chosen LIC.

In its September 30, 2006, summary of listed managed investments, the ASX lists six private equity funds, including Colonial Private Equity (CFI), Macquarie Private Capital (MPG), Souls Private Equity (SOE) and CVC Limited (CVC). Of these, only two had historical data showing five-year returns, with CVC posting an annual return of 20.99% and Colonial Private Equity 4.59% (five years to the end of September, 2006).

Allco Equity Partners and Babcock & Brown Capital would also be categorised as listed private equity funds. Many of the biggest LICs joined the ASX in the past 18 months and several of the leading funds with more than $1 billion in assets, such as Allco, Macquarie and Babcock & Brown, had a poor start with the stocks trading often trading below issue price. More recently there has been an improvement in prices reflecting the maturing portfolio in several of the funds.

A benefit of using listed investment companies for private equity exposure within your portfolio is that listed investment companies can continue to trade at a discount to the value of their assets from some time, offering an interesting purchasing opportunity. For example, as of December 31, 2006, Souls Private Equity had a portfolio valued at 27¢ a share, yet the last trade was at 20.5¢ a share.

Buying a 27¢ portfolio for 20.5¢ is an interesting proposition.

Private equity style LICS are much more transparent than the unlisted variety and when you are holding an investment over a long period this can be reassuring. The requirements for "continuous disclosure" under ASX listing rules means that you get a good flow of information about how the private equity listed investment company is performing, including acquisitions, asset valuations and asset sales. Indeed, if you are looking at buying a private equity listed investment company, one of the first places of research should be the historical company announcements on the ASX website.

Should retail investors access private equity?

ASIC's executive director of consumer protection, Greg Tanzer, is quoted on the regulator's financial information website "Fido", suggesting: "Our message is simple: if you don't understand the investment, don't buy it."

This is a pretty good rule of thumb but I'm also prepared to say private equity is understandable and it can make sense for many investors. You are investing in a fund that buys unlisted, smaller companies, and grows those businesses until they can be listed on the stock exchange at a profit. Of course, investing in smaller unlisted companies is risky and an acknowledgment of this risk should underpin any investment decision.

The other factor going against private equity investment at the moment is that it is such a competitive environment. In a previous article entitled Exploring the ‘alternatives' I looked at the trend for large superannuation managers to use alternative investments, and we are all aware of the large overseas private equity money competing for investments opportunities.

There is only be a finite pool of private equity investments, and one risk of investing in the sector now while it is all the rage is that the competition for private equity investments will push their prices up, and push down the future returns.

Of course, if you are investing in private equity through either a listed investment company or a managed fund it must be a long term process: value is not created until the fund or listed investment company makes a business purchase, positions the purchase for growth and then relists it. This is a five to 10 year cycle.

Keep in mind the other warnings in this article about high costs, the illiquidity of the managed fund option, the long time frame and the relatively high minimum investments required. You don't really want to put $50,000 into a private equity managed fund if your total portfolio is only worth $100,000.

That said, using alternate assets for 5-10% of your portfolio is a common portfolio strategy. Private equity fits well within the alternate asset category, and can be an interesting investment experience as you follow your fund purchasing, improving and ultimately reselling businesses.

The private equity investments available to retail investors in Australia are not the sort that will be sniffing around and looking to buy a company the size of say, Telstra, however these investments are well worth thinking about as part of your portfolio.

Disclosure: Scott Francis, a Brisbane-based financial planner, holds investments in the Gresham Private Equity Fund No 2.