(June-2003) PE: Is it safe to go back into the water?

The popularity of private equity may have taken a recent nosedive, but as managers gain more experience and the sector develops, investors are being lured back.

Following serious growth in the sector over the previous four years, 2002 brought negative returns for many private equity investors.

The Australian market grew from 1998 levels of under $300 million being raised and $270 million invested, to $1.4 billion raised and $2 billion invested in 2001. But a mere $300 millions was raised and $450 million invested in 2002.

This plummet is being attributed to the ‘tech wreck’ in the US and a collapse of listed equity markets, which spilled into the private equity sector.

Ian Court, CEO for fund manager DAF, says: “People were nervous about committing capital to higher risk sectors such as private equity.”

However, asset consultants are advising super fund clients to return to the sector. Bruce Gregor, Mercer’s research leader for private equity in Australia, says despite a downturn in returns, private equity remains an appropriate investment avenue as part of a diversified portfolio.

This optimism for private equity is common across the industry. Australian Venture Capital Association CEO Andrew Green notes that because markets have fallen, there are good investment prices, significant chunks of capital to invest, and a pool of skilled managers out there.

This is a good time to execute buyouts, particularly in early stage technology, says Green. “The world is pre-occupied with SARS and Iraq, so asset prices have depreciated and behind the scenes, there is a buzz of activity and businesses are doing well.”

He cites recent successes as the $750 million acquisition of Pacific Brand by Catalyst and CVC Asia Pacific, and purchase of REPCO by Pacific Brand. “Both are performing well and there are more opportunities for similar deals,” he says.

In his opinion, those who do not look at private equity are missing out, as the class historically outperforms other investments. “You should not put all your eggs in one basket, but it is not prudent to have nothing in private equity,” says Green.

Court agrees that big money can be made in the next two to three years, providing investors act consistently.

Such measures of caution are typical of the private equity market, which can be complex and difficult to negotiate. Gregor says investors should commit to a program of 10 to 15 years, and take example from industry, endowment and perpetual funds, such as Harvard or Yale University Foundation.

However, Australian investors lack the long time horizon needed for private equity, warns Gregor, especially as super funds allow investors to move their money around at short notice.

Fund secretary and director of the Master Super Fund Mark Sladden believes that those investing over a five to 20 year period should have exposure to private equity.

“The nature of the investment is that it’s complex, not for the light-hearted, long-term, and you do not get into it quickly,” he says.

These characteristics have somewhat stunted growth in private equity investment. The market in Australia is still emerging, is not very mature, and lacks the depth of experience seen in the UK, US and parts of Europe.

Sladden’s fund made its first private equity investment at the end of 2002 but has been around for 40 years: “I would not say private equity is a popular choice. It is increasing, but not overnight,” he says.

There has been limited private equity activity to date, with around $8 billion committed or invested to the asset class out of a total super pool of above $500 billion.

Green believes that with less than 5 per cent of super funds investing in private equity, the market should become three to six times bigger than its current size within five to 15 years, given the critical mass of funds, the type of managers around, and industry coming of age.

Sladden agrees. He says over time, private equity is becoming an increasing source of diversification and will see both higher returns and greater interest.

Court adds that there is little public information available on private equity, which may have limited growth but also presents gaps to the willing.

He says: “Herein lies the opportunity. Investors can expect high returns with such an information gap and just a few managers with key market data.”

The market in Australia is starting to establish a track record and should become more sophisticated, with bigger deals and returns for investors.

Experts believe that the market decline in 2002 should lead to a capital shortage, bringing competition over prices.

Court says: “Entry prices will be low, so with low-valued companies, there are opportunities to get bargains.”

In Green’s opinion, there is no question that the Australian private equity market will grow. “There are enough deals to show the way for future investors and their performance continues to justify commitment to the sector.”

He adds that new legislation allowing venture capital limited partnerships in Australia should make the country an attractive prospect to foreign pension fund investors, who will no longer be subject to capital gains tax.

Green notes: “The Government realised it was depriving the economy of a lot of capital available around the world. This now levels the playing field.”

Further reasons for growth could be that small companies used to go to the listed market to raise capital through IPOs, but according to Court, this path has closed in the last few months and more investors will therefore be looking to private equity to fill this gap.

In terms of allocation, Australian levels are slightly lower at 5 per cent, 8 to 10 per cent at the extreme, than in the US, though somewhat above those in Europe, says Gregor.

He attributes this to historical reasons, with tax legislation affecting growth and the fact that the Australian economy has been thriving, making the economy here an attractive investment.

Super fund portfolios have seen an increase in their private equity allocation, relative to their overall portfolio, as values have depreciated.

In terms of actual funds, Master Super Fund has $45 million committed to private equity but will take a number of years to reach this target. It has two fund-of-funds managers, with three managers in one, and two in the other, which manage five underlying funds in total.

Gregor says investors are beginning to diversify with different managers, through fund-of-funds and individual portfolios. “It is best to review and switch fund managers. Using fund-of-funds is a safer way to invest, as you spread risk and achieve diversification,” he says.

Expected returns for private equity funds are between 15 and 25 per cent a year, according to Sladden, depending on the type of investment. He says: “Going forward, such amounts will be harder to achieve, but the amount will always be 6 per cent above equity markets, otherwise it would not be worth it.”

DAF has been busy developing DAF III, its third generation fund-of-funds, which is expected to raise $350 million in the next two months.

The fund, which has 15 to 20 managers and a portfolio of 150 to 250 companies, aims to diversify across a number of sectors, companies and business stages, leading to a split of 15 per cent in the high-risk early venture capital stage, 35 per cent in expansion, 45 per cent in low-risk management buyouts, and 5 per cent in other sectors. DAF II has 9 investors, DAF III 12, with an average of $60 million each, and DAF IV, expected to launch between 2006 and 2007, should be even bigger.