Research published recently by iPEIT showed that wealth and fund managers have been increasing their exposure to listed private equity, specifically London-listed Private Equity Investment Trusts.

Research published recently by iPEIT showed that wealth and fund managers have been increasing their exposure to listed private equity, specifically London-listed Private Equity Investment Trusts (PEITs). This comes in spite of, or even perhaps because of, market sentiment being less favourable at the end of 2007 towards an asset class that relies, in part, on the availability of debt and has, therefore, been affected by the slowdown in the credit market.

The apparent disconnect is not surprising. Experienced advisors and investors understand that, although private equity is a form of equity and therefore not immune from falls in the listed markets, the presence of uncertainty provides fertile conditions for the generation of strong long-term returns.

Furthermore, diversification within listed private equity provides some protection against industry cycles. Investors in any single PEIT will, typically, gain exposure to a range of differing vintages (year of investment) and industry sectors and, in many PEITs, to different geographies and stages of company, from start ups through expansion and small buyouts to large buyouts. Returns are thus not dependent on any one particular year or any single type of private equity investment.

That said, a slowdown in economic growth affects business activity to which private equity is sensitive: building value in businesses will take longer. Experienced fund managers have been here before, notably in 1992/1993 and 2001/2002. At each of these times, economic growth and the availability of capital slipped, or got knocked down. In such conditions, valuations adjust downwards to reflect new conditions and market outlook.

We have, until recently, had a long bull run fuelled by healthy economies and easy credit. Private equity exits have produced above-trend returns. As the credit cycle has evolved, questions have been raised as to whether private equity portfolios are at risk due to excessive leverage.

As always, this market has exhibited a great disparity of performance between the top quartile managers and those with average or below-average performance. Experience shows us that good managers perform well, even in a difficult environment. If the downturn were to become more protracted, it would not necessarily follow that the incidence of bankruptcies in private equity portfolios would be high.

Moreover, reduced valuations today may present some attractive buying opportunities.

Growth in mid-market buyouts and venture capital investment is expected to continue, even if the market for the largest buyouts is now closed.

The same could be said for investors in PEITs. Market sentiment has driven discounts to levels that we have not seen for some years and history shows us that those who have bought shares in PEITs at significant discounts to NAV have done well in the long term. (charts)

Private equity is seen by many as a more effective form of ownership for many businesses than the public markets, due to the close alignment of interests between shareholders and managers. The industry is now mature but, in terms of global capital, has plenty of room for growth. Global enterprise value exceeds $40 trillion; private equity’s global purchasing power today is considered to be less that $2 trillion.

We are sometimes asked about “cash drag” (the effect on the performance of a PEIT due to cash sitting on the balance sheet before being put to work). PEITs aim to use cash strategically to acquire assets at favourable periods of the investment cycle. Many PEITs aim to maintain minimal cash holdings. In addition, PEITs may borrow capital to finance investment. The fact is that private equity investment is opportunistic in nature and liquidity needs to be managed in order to make investments when opportunities arise. Because PEITs are “evergreen” vehicles with permanent capital, managing cash can be challenging.

Should private equity be allocated in portfolios as an equity or as an alternative asset? Although it is by nature equity, most institutions investing in private equity see it as an alternative asset class, due to its absolute return profile and relative illiquidity.

iPEIT’s 2007 survey of wealth managers showed a notable shift in this group also towards treating listed private equity as an alternative asset. In other words, investment in PEITs is being used by wealth managers strategically for diversification. Analyst coverage of PEITs has increased in recent years and it is apparent from such coverage too that PEITs tend to be categorised as alternative investments.

It is important to recognise that PEITS invest in funds or individual companies to achieve long term capital growth. They should not be confused with other types of investment vehicle with different market focus, such as structured debt funds that acquire large portfolios of loans on a very highly leveraged basis.

Established listed private equity vehicles have performed well across a number of cycles. AIC data demonstrates that long term performance over any ten year period since 1991 has exceeded most other types of investment.

One of the largest obstacles facing PEITs is that awareness of them tends to be limited to the largest and more experienced advisors. We are all working to ensure that more advisors and their clients know that private equity can be accessed for the price of a single share – and that, for institutions, listed vehicles offer a route to meeting their allocation targets faster than, or alongside, limited partnership funds.

Andrew Lebus, Pantheon International Participations
Ross Marshall, Dunedin Enterprise Investment Trust