With the dust still settling after World War II, British policymakers began to turn their attention to what had been called “a chronic shortage of long-term investment capital for small and medium-sized businesses.”  The result was the Industrial and Commercial Financial Corporation (ICFC), a pool of capital funded by major British banks.  Fast forward to July 1994, and the successor to the ICFC – now known as “3i” became one of the first private equity funds to be listed on an exchange.

Since then, many other private equity funds have listed themselves – most notably in the UK.  In fact, one might even say that listed private equity funds have blazed a trail for the recent wave of hedge fund ETFs.

A new study of this branch in the private equity family tree sheds light on which types of institutional investors allocate capital to these funds, and why they have grabbed the attention of investors.  The paper, by Douglas Cumming of Canada’s York University (see related post), Grant Fleming, a visit professor at the Australian National University, and Sofia Johan of the Tilburg Law and Economic Center, examines the private equity allocations of 100 European institutions and finds that 43% invest in listed PE funds – allocating an average of just over 6% of their capital to them.

As you can see from the chart below (created with data from the paper), organizations that invested in listed PE made extensive use of consultants.  In addition, they were the only PE investors to use their existing equities teams to manage the allocation.  As the authors suggest, this is likely because listed PE funds are, technically speaking, listed equities.

In addition, listed PE investors were more commonly private pension funds, rather than public ones.   According to the paper, part of this could be due to the smaller size of private funds – and therefore their smaller capacity to conduct due diligence on LP investments.

One of the problems with traditional (LP) PE investing is that capital may be deployed quite slowly as the GP searches for investment opportunities.  As a result, full PE exposure may not be reached until several years after the initial capital commitment is made.  To compound this problem the time line for ramping up this exposure is in the hands of the GP, not the LP.

As the paper points out, listed PE funds allow institutional investors to get PE exposure immediately.  And in fact, institutions seem to take advantage of this benefit.  Those that invest in listed PE are 15% more likely to adjust their allocations over time.  In addition, listed PE investors are 9% closer to their desired private equity allocation compared to institutions that invest using LPs.

In conclusion, Cumming, Fleming and Johan suggest that listed PE may be a growing asset class as defined benefit plans switch to defined contribution plans and put decision-making into the hands of unit-holders themselves.

Which makes us wonder if hedge fund ETFs may ride the same tail wind…

By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

The secondary market for private equity interests has received lots of attention over the past year, but according to Michael Pugatch Vice President at HarbourVest Partners (writing in the Guest Column of the latest Debevoise & Plimpton Private Equity Report), the long-awaited “golden age” for secondaries did not transpire in 2009. However, the market has evolved and signs are pointing to an increase in transactions in 2010.

Sellers Remorse?

Historically, only large financial institutions and corporations have participated in the secondary market. Pugatch states that as a direct result of the financial crisis, several endowments and publicly traded private equity funds also entered the market in early 2009 (mostly as sellers).

For endowments, the need for current or future liquidity and the desire to reduce private equity allocations are the top reasons for wanting to sell. The latter is due to both the decrease in the valuation of public assets in 2008 and Q1 09, and the increase in risk aversion following the crisis. Last week’s post provides an overview of the Coller Capital private equity investor survey, which reaches a similar conclusion. For publicly traded funds, leveraged over-investment in private partnerships – a winning strategy during the 07-08 heyday – backfired when distributions ceased and liquidity became nonexistent.

Buyers Market

Buyers of secondary interests have traditionally been specialized firms that actively acquire private equity stakes, such as secondary private equity funds. Most recently, non-traditional buyers like insurance companies, pension funds and some endowments have entered the market as buyers to opportunistically increase their stakes in certain partnerships at an attractive price.

Active buyers of secondary interests dramatically scaled back their purchases in the second half of 2008 and the first half of 2009. Market uncertainty was obviously a factor, and a general lack of confidence in the valuation of private equity portfolio assets compounded the problem. Secondary bids dropped dramatically, falling as low as 30% of NAV for some partnerships, which in turn further decreased the number of secondary deals . Even the most cash-strapped investors were understandably reluctant to part with their private equity stakes for pennies on the dollar.

The Great Flood

HarbourVest expects that and increase in deal activity and the resulting increase in capital calls should spark the long awaited secondary market flood. Since capital calls have been minimal in the first half of 2009 (see chart below), and have picked up as the recovery has gained momentum, he speculates that some investors will face immediate liquidity concerns and will be forced to sell on the secondary market.

Last Resort

Will 2010 be the year that the private equity secondary market finally becomes a viable portfolio management tool? It will likely take longer than most had hoped. The reason is the level of complexity involved when valuing a private equity portfolio.

To keep things relatively simple, assume that the fund is fully invested. The first step is to value each individual company in the portfolio. Since the financials are not publicly available, the only option is to try to guess or take the FAS157 valuation as a fact. Unless of course, you either already own a stake in this particular fund or have a great relationship with the GP, in which case you can probably get a pretty good sense of how things are going.

Even if you were able to get a relatively accurate valuation of the portfolio assets, you are not done. Unlike a mutual fund manager, the GP has an active role in each portfolio company, which needs to be factored into the calculation (perhaps you already factored it into the discount rate for each company, but that is a longer discussion). Next, adjust for the vintage year (a proxy for purchase price for each company), already paid-out distributions, the fee structure, and any other factors that could affect the future distributions from the fund.

The level of complexity that is involved in valuing a secondary market portfolio favors buyers with lots of money already invested in private equity partnerships, lots of experience and many good relationships with GPs. Average sized pension funds, endowments, MFOs and individual investors are clearly at an informational disadvantage relative to secondary funds and large private equity investors. Until the information gap is narrowed, the private equity secondary market will continue to be viewed as a last resort for most investors.

Last summer, we reported on the changing face of private equity, as reflected in a nifty semi-annual publication from private equity firm Coller Capital.  The firm recently published its winter edition showing that much has changed in the world of private equity in a relatively short amount of time.

For starters, return expectations have taken a hit.  The proportion of survey respondents that expected 16%+ annual returns in the mid-term (3-5 years) has fallen by a quarter (see chart below from report). More…

Apparently it’s not just hedge funds that are now being held to a much higher standard when it comes to demands for transparency by institutional investors.

According to a recent survey published by SEI (downloadable with free registration here), financial advisors and other investors, private equity (PE) shops are also under increasing pressure to provide higher quality reporting and more “look-through” ability to their existing and potential investors. More…

Since well before the days of Gordon Gekko, regulators and policymakers have pondered whether vulture capitalists add value or simply destroy what little hope is left for ailing companies.

In general, research seems to suggest that private equity firms (of both the vulture and non-vulture persuasion) add significant social value (see AllAboutAlpha.com coverage) by reducing, not increasing the rate of bankruptcy of target companies.  Other studies have found that activist hedge funds are also associated with more successful outcomes – but mainly because they know how to pick the winning situations before diving in (see AllAboutAlpha.com coverage).  And further research suggests that activist hedge funds serve an important role in keeping management honest – a role some say should be played more aggressively by institutional investors (see AllAboutAlpha.com coverage).

A study released last month adds to the evidence that activist hedge funds add long-term value.  In an unfortunately titled paper (given recent blow-ups) called “Hedge Funds in Chapter 11″, Wei Jiang of Columbia, Kai Li of the University of British Columbia and Wei Wang of Canada’s prestigious Queen’s University (disclosure: am an alumnus) argue that the involvement of activist hedge funds in distressed situations is a predictor of better outcomes.

How much better?  When the trio compared the returns of Chapter 11 cases where hedge funds as major creditors with returns from Chapter 11 cases where hedge funds were absent, they found that hedge fund involvement was good news… More…

Apparently hedge funds aren’t the only ones having doors slammed in their faces these days.

According to a report released this week by PREQIN (Private Equity, Real Estate, Hedge Funds, Infrastructure), private equity real estate funds worldwide raised just $4.9 billion in the third quarter, the lowest quarterly fundraising total since 2003.

While at first blush one might presume it’s the lousy U.S. real estate market’s fault, in reality it’s more a reflection of investors’ still-cautious appetite for deals, and in turn their cautious appetite for investing in funds that invest in deals.

Indeed, many investors remain capital-constrained, or are being cautious about committing to firms until they are sure the funds can hit a certain minimum level.

PE Real Estate Fundraising

“Investors are very cautious, with many having seen significant declines in their real estate portfolios and are reluctant to commit to new vehicles,” says PREQIN.

With banks slow to write down the value of their real-estate portfolios, investors may not feel the need to rush back into the market, the report says.

No kidding.

The reality is that despite huge amounts of cash on the sidelines, most investors, particularly institutions, are keeping away from longer-term, somewhat-illiquid vehicles, never mind those focused on real estate.

What it boils down to is the losses private equity funds and everyone else took in 2008 — and convincing investors in the aftermath that those losses were a one-off event. Add to that still-tight credit markets and deal flow for private equity firms remains stagnant, whether real estate or anything else.

Quarterly figures recently released by Dow Jones Private Equity Analyst are a case in point: In the third quarter, 72 funds secured $25.2 billion, a 70% drop from a year ago. Year-to-date, buyout shops have seen fundraising slide 59%, from $195 billion raised by 315 funds through the third-quarter 2008 to only $79.9 billion thus far in 2009.

A separate report this week by Hedge Fund Intelligence noting hedge fund assets under management have also continued to decline shows the exact same thing.

A case of concern over a still-sour housing market, or a case of cold feet and hard lessons among investors? We’re betting both.

By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

Private equity funds can bring many valuable qualities to a portfolio.  But critics of the asset class  sometimes charge that its defining characteristic is its high fees and relatively low performance.   Yet investors continue to invest in new funds. Is it possible that some investors are “fooled” into investing in buyout funds?  This is the question posed by Ludovic Phalippou of the University of Amsterdam in a new paper called “Beware of Venturing into Private Equity”.  Phalippou focuses his critique on buy-out funds.

Fee-for-all

He cites two studies to show that after fees, the average buyout fund underperforms the S&P 500 Index; however, gross-of-fees, the average fund is able to outperform.   So how much does it really cost to invest in a buyout fund?

Using a proprietary collection of fund-raising prospectuses, Phalippou dissects the key compensation terms for a typical fund:

• Management Fee – annual fee, typically 2 percent of the capital committed until the end of the five year investment period, at which point it is applied invested capital only.
• Carried Interest – annual incentive fee that is based on the returns earned by the fund, given that a hurdle rate of 8% is met.
• Portfolio Company Fees – fees taken directly from portfolio companies that include: transaction fees; termination fees; legal and accounting fees; monitoring fees; and director fees.  Contracts typically do not specify the level or timing of fees, despite the fact that these fees can account for as much as one-third of all fees charged by the fund. A portion of these fees are rebated to LPs, although actual amounts differ vastly between funds.

Using figures that are representative of fund performance, Phalippou calculates the fee amount charged as an annual percentage of the invested amount – or, the equivalent amount an equity mutual fund would have to charge to collect the same amount of fees. That amount comes out to a staggering 7% per year, which appears excessive – especially for an investment that underperforms the S&P 500.

A Small Misunderstanding…

Despite less-than-stellar performance and apparently egregious fees, buyout funds appear to have no problem attracting investors.  The two potential reasons behind this phenomenon appear to be 1) minor differences in opaque fee contracts that lead to disproportionally larger fees and 2) exaggerated performance figures.

Effective management fees, for example, can be significantly higher than the nominal 2% fee stated in the contract. Because funds typically levy the fee on the amount of capital committed – but not actually invested – the effective fee (i.e. the amount charged relative to the amount actually invested) can vary substantially across funds; it depends on how much of the committed capital is actually invested.

Carried interest calculations create even greater levels of variance in paid fees, despite the fact that most funds do not deviate from the 20% of profits with an 8% hurdle rate structure. Portfolio company fees are not specified in advance, despite the fact that it appears that these levels vary greatly across funds. Further, some firms even deny investor requests for records of previously charged fees that can be used to estimate future fees. Because of the hidden complexity of the fee contracts, investors will often have great difficulty comparing contracts and anticipating future fee payments.

On the other hand, inflated performance figures often result from various reporting problems; lack of reporting of negative IRRs for low multiples (see chart below), overvaluing poorly performing investments, using IRR flaws to improve performance, and sample bias often lead to inflated performance. Lack of detail in fundraising prospectuses further compounds the problem; for example, omission of the relevant time periods and leverage levels make the reported multiples difficult to gauge.

Not Smart Enough for Their Own Good?

Phalippou reaches the conclusion that investors continue to invest in buyout funds because of a combination of a) the high level of complexity of the information regarding fees and performance and b) a lack of expertise on the part of some investors. The fact that funds often refuse to provide additional information to smaller investors further compounds the problem, making learning from past experience or comparing fee structures between funds extremely difficult. It seems that some investors are indeed “fooled” into investing in new funds.

Even if the flaws Phalippou discusses are eventually corrected, other factors may allow the “low-performance-high-fees” phenomenon to persist. Overconfidence and herding biases are surely as rampant in private equity investing as they are in traditional equity markets. And because no passive investment alternative for private equity exists means that investors have little choice but to continue writing hefty fee checks to fund managers. Lastly, because funds don’t compete on the basis of cost – performance is the main product differentiator – there is little hope that, at some point, increased competition will drive down fees.

By: Steve Wallace, AllAboutAlpha.com Editorial Board

I remember being introduced to SRI (Socially Responsible Investing) when I started my career at a financial planning practice in Australia.  That was well before the turn of the century and the subsequent ascendancy of SRI (and its cousin Environmental, Social and Governance policies or ESG) as an investment criterion.

Over the ensuing years SRI and ESG investment products have come in and out of favour.  The main reason for this on-again off-again relationship between these funds and their investors has been performance – or more specifically, the difficulty in attributing that portion of a company’s performance which results specifically from its ESG policy.

That issue remains today, but so much attention has been lavished on climate change and environmental sustainability that these topics may have finally become part of the mainstream investing consciousness.

Private equity managers, by virtue of their in-depth analysis of company strategy, are particularly well positioned to determine whether ESG is a secular or a cycle trend.  So what do private equity investors think of the integration of ESG criteria into private equity decision making?  This is a question posed in a recent report by the Novethic Research Centre based on a survey of French private equity managers.

According to the survey, less than a tenth of private equity firms were involved with “environment funds” per se… More…

By:  Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board

A recent survey of institutional investors done by London-based Preqin (Research Report: Fund Terms After the Crash) is indicating that a new trend is emerging in private equity investing. After a period of several years during which investors slowly conceded more and more negotiating power to the GP, the balance of power has began to shift back to the LPs. This is not surprising, given the developments over the past year and the current investing environment. Many investors have begun to question whether private equity is really a unique asset class with excellent diversification benefits, or just a form of extremely opaque, highly leveraged equity investing. Further, the fundraising environment remains highly competitive as many potential investors are facing an unprecedented liquidity crunch, and have neither the ability nor the willingness to invest in new funds.

Tipping the Scales

As the aura surrounding private equity managers began to fade in late 2008, investors began to reassess the lenient terms and conditions granted to GPs during rosier times. While little could be done regarding existing funds, new offerings provided prospective LPs with ample opportunity to seek more favorable terms and conditions going forward. It seems that a significant amount of institutional investors were able to take advantage of this opportunity; the survey result shows that 43% of respondents felt that the balance of power in negotiating new fund terms and conditions has shifted towards the LP during the past six months. More…

“Innovation” is often held up as the engine of growth for modern economies.  Technological innovation, business process innovation, even social innovation, have carried the hopes and dreams of companies and economies alike.

Then there’s financial innovation.

This new four letter word has been blamed for everything from the economic crisis to the cooler than normal summer in the Northeastern US.  But we contend what some have termed “pure financial innovation” is much different than innovation in the financial services industry.

A new report on the global asset management industry from the Boston Consulting Group makes this point in spades (available here with free registration).  The report argues that after the fiasco of the past couple of years, institutional investors will demand “innovations” such as alternative investments.

Says BCG:

“Institutional investors have sustained substantial losses during the crisis despite highly diversified strategies.  They will likely continue to increase the diversification of their portfolios and seek innovation to help them achieve this goal.”

So what kind of “innovation” will they seek?  The chart below from the report answers this question: More…