|04 April, 2019

Private Equity: A risk worth taking?

The private equity industry claims to offer superior returns to equity markets, but only the top quartile of fund managers have achieved this

Employees work in an office of the Nissan Design Studio in Beijing

Employees work in an office of the Nissan Design Studio in Beijing

REUTERS/Handout .

Private equity is any stake in a company which is not publicly traded or listed.

Private equity investors either invest in private companies or buy up shares in public companies so that they can take them private.

Investors often take over large public corporations which have been struggling and take them private in the hope of making the company profitable again or stripping out the profitable bits and selling them on.

At the other end of the scale, investors also buy chunks of very young companies so that they can expand much more quickly than would otherwise be possible in the hope of high returns. This is known as venture capital.

Some companies like to turn to private equity funding became it gives them access to larger amounts of money than they may have affordably been able to borrow from banks in order to fund a period of rapid growth.

It also gives the company's leadership team the ability to pursue growth strategies away from the scrutiny of public markets because private companies are not required to disclose as much information publicly as those whose shares are listed on exchanges.

On the other hand, it usually means that a company's former owners or founders often have to give up financial control and forego much of the profit they might otherwise have made going it alone.

For investors, the benefits of putting money in private equity can be enormous. For example, Careem and Souq.com were both launched as privately-held companies in the Middle East and grew to become market leaders before being acquired by global players looking to boost their regional footprint – Uber and Amazon respectively.

Experts say that fields such as technology, healthcare, business services and technology services have been particularly popular with private equity investors in recent years.

Deep pockets required

However, investing in private equity comes with its own problems. Firstly, companies usually require a lot of money to fund their expansion so any meaningful investment requires a large amount of cash. Consequently, even investors who buy private equity stakes through a firm or fund generally have to shell out large minimum investments which can range from the mid $200,000 range to several million dollars, leaving this form of investment out of the hands of all but the very wealthy.

Private equity firms are run by General Partners, (GPs). The investors who put cash into these ventures are known as Limited Partners (LPs), and usually consist of wealthy individuals, pension funds, family offices and sources which pool money to buy companies, work with managers to grow them and then sell them on for what they hope will generate sizeable returns.

Typically, a fund (or GP) invests its committed capital into 10-12 (mainly private) companies. It then manages the portfolio of investments and seeks to exit the investments within a specified timeframe – usually around five-to-seven years later.

In exchange for managing the fund, the GP usually charges investors around 2 per cent of the value of the assets in the fund each year. Also, once the investments have been sold on, the team also charges a “performance fee”, which is typically around 20 per cent of the profits generated.

Corporate expansion or turnaround can be a risky business, with many ventures failing completely. Most venture capitalists estimate that only around a third of their investments will bring in profits, making up for a third which make losses and another third which just cover the capital spent.

One in four

Boston Consulting Group research shows that only the top quartile of fund managers has outperformed equity markets globally while second quartile managers only provide returns that have been similar to fixed income returns. Funds of third and fourth quintile managers have either reverted into no returns or have led to losses.

“Private equity is still an attractive asset class offering above equity market returns in the long run. However, investors have to keep in mind that private equity investments are less liquid and will require two to four years until the full amount is invested. In addition, the rising valuation levels will most likely reduce the expected returns of funds, which are currently issued,” says Markus Massi, senior partner and managing director at The Boston Consulting Group.

And thirdly, even if these strategies do succeed they can take a long time, leaving investors without access to their money for a number of years.  Because shares are not publicly traded, getting a valuation for your investment can be very difficult. And, finding an exit strategy to sell your stake can also be tricky.

In the Gulf in particular, one of the big problems for private equity investors is the relatively small number of companies undertaking IPOs on equity markets which are still classified as ‘frontier’ and ‘emerging’.

While the number of IPOs has grown in recent years, most activity has been focussed on large, state-owned enterprises. This is expected to change over the long term as these markets mature, in turn creating more venture capital and private equity activity in the region.

Moreover, experts say that an increase in competition for deals all around the world is pushing up valuations and making some private equity deals less profitable for investors.

“Investment dollars are indeed up, but deal count has dropped substantially since 2014. Multiples are at all-time highs, with around half of all companies acquired priced in excess of 11 times earnings before interest, taxes, depreciation and amortization,” says Hugh MacArthur, head of global private equity at Bain & Co in the company's most recent private equity report.

“In such a frothy environment, funds are turning to a mix of tactics and strategies. On the tactical side, we see investors aggressively assessing and measuring portfolio management talent, an area where the margins for error are thin and getting thinner,” he adds. “They are also exploring how the pace of technological change is altering industry profit pools, with an eye toward taking advantage of new opportunities before others see them and avoiding pitfalls prior to investment.”

The Boston Consulting Group's Massi agrees. He says that the strength of the US dollar to which most GCC currencies are pegged is also deterring international private equity investors from buying stakes in some Gulf companies.

“The private equity market in the GCC is currently going through a significant structural change,” he says. “Larger peers are refocusing their attention and efforts outside of the GCC and smaller private equity firms are facing challenges finding the right projects, as larger deals are typically implemented by strategic or industry buyers. While the general investor appetite for regional assets is still healthy, regional private equity firms in the market require significant upgrades to their operations, communication and investor relations.”

(Reporting by Lucy Barnard; Editing by Michael Fahy)

(michael.fahy@refinitiv.com)

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