Private Equity & Finance

In a study released in January 2009, four authors from the University of Basel (Switzerland) and the company LPX discuss the pertinence and aim of listed private equity (which has its own association now).

Even if published as a scientific paper on the NBER website, the paper is strongly biased in favour of listed private equity. LPX competes with S&P as regard to imposing its index on this « sector» . The underlying purpose is of course to set an index supposedly representative of private equity as an asset class and give an exposure to investors supposedly economically and effectively. As a matter of fact, Société Générale created an ETF on one of LPX’s index.

Writing a white paper is not criticizable, as it serves a double aim: explaining and selling. It’s the corporate equivalent of « advertorials» , combining advertisement and editorial. What is unfair is to publish a white paper under a « scientific umbrella»  – here the University of Basel.

What is raising these concerns?

1. the authors regroup very different vehicles under « private equity company» : evergreen funds, management companies (general partners), holdings (i.e., funds + management company in one structure), funds of funds… Do they integrate SPACs (Special Purpose Acquisition Companies) in their analysis? Because that’s listed PE. They do not provide any information on that. That leads to a scientific bias from the start, as these structures are different in their purpose and financial behaviour (income streams, etc.). Even worse, the figures exclude « non surviving»  companies (figure 2), meaning that the base never shrinks.

2. the authors do not address the reasons why the original owners listed their structures, which could explain why there were « waves»  of listings. That could hint of the validity of investing in such structures.

3. there is a confusion about who are the potential investors in these listed structures. Are they retail investors (which are sometimes mentioned) or institutions (as it seems that the paper is trying to target)? If it is both, then the paper needs to differentiate them as they have different investment target and behaviors.

More into details:

1. Quote: ‘The typical private equity features such as investment styles, financing styles and other important characteristics are shared between the unlisted and listed private equity universe.’

That does not mean that one is worth the other:

> In the unlisted world, limited partners can negotiate the terms of their investments in funds for example, which a retail investor in a listed structure cannot.

> In the unlisted world, limited partners have a rather clear idea of what will be the fees charged by general partners/fund managers, which are rather difficult to see in a holding structure. Moreover, once set in the limited partnership agreement, they cannot be exceeded. There is no such limit for a listed holding for example.

> In the unlisted world, transparency is comparatively higher than with public structures. Limited partnerships, we have quarterly updates, with details about portfolio companies evolution, wrap up about every company in the portfolio. We also have an annual meeting and a direct access to the fund managers. Listed funds or holdings do not provide this level of details, notably for non listed companies in their portfolio, hence the discount at which they are traded (black box effect).

2. Supposedly, listed private equity offers a ‘flexible investment horizon‘ (p. 2) and ‘ highly liquidity‘ (p. 4)

This is rather untrue for the second, as the liquidity is relative to the daily exchanges, which may be rather low (notably if the floating part is small and the investor has a substantial block of shares). As for the first, we will discuss it later in this post as this is rather unclear if it is for the investor or for the listed structure.

3. Is the discount negotiated on private placement secondaries is higher than the permanent discount to net asset value to listed private equity structures? That would have been a rather good question to look at before calling listed private equity a good substitute to private structures. Indeed, some private secondaries are negotiated at a premium, and the price varies greatly depending on the maturity of the portfolio.

4. Contrary to what is stated in the paper (p. 3-4), cash management is sub-optimal in listed structures compared to private structures. As a matter of fact, limited partners/investors commit to pay over the course of five years as opportunities appear through capital calls. They can use the cash meanwhile as they wish, and get the dividends of this cash management. The distributions (long term profits, low or no taxes) are made as soon as the cash is available.

An investor in a listed structure has no choice but pay upfront for what he gets. However, there is no other distribution than annual dividends (which are heavily taxed) and the cash can sit idle in the balance sheet of the structure while waiting for another investment opportunity.

5. The tax issue is rather crucial indeed, and not addressed at all. The net return of an investor in listed structures after taxes should be rather different than the one in an unlisted structure. This is unfortunately not addressed.

6. Groundless statement (1): ‘A pioneer is identifying and researching the global listed private equity universe is Swiss-based LPX. Their listed private equity index family [... is] accepted as a reliable tool for valuation and representative benchmarks for private equity in both the academic and industry experts‘ (p. 5).

Normally here, you would expect heavy references such as (name, date) – at least, this is what they usually do in the « academic world» . But there’s none.

Now let’s stake the highlighted words:

> « reliable tool» : Really? Given the correlation of LPX indexes with the stock market indexes, I would not call that « reliable» . Unlisted private equity is partly decorrelated in terms of cycle of investments and also in terms of valuations and volatility. If the index does not reflect that, why is it reliable?

> « valuation» : Of what exactly? Underlying porftolio companies? I wonder how. A fund? The net asset value of a fund is the sum of its portfolio companies as assessed by the general partner/fund manager.

> « representative benchmark» : now, raise your hands people who have heard of LPX out of Switzerland. The real « benchmark»  if there would be one, is Thomson Venturexpert categories. And they are far from being perfect: incomplete (partial vintage, no fund of funds index…), rough (LBO and… non-LBO worlds) and mainly tracking only a portion of the universe. An alternative would be State Street for the overall sector. A few other providers such as Cambridge Associates are also on the track. But LPX? Not sure about that.

7. Groundless statement (2): ‘For an investor it is the same to participate in a buyout deal financed with equity or mezzanine capital via an unlisted or a listed private equity company‘.

I would like to meet this ‘investor’ and have a chat with him. I am not sure that he exists, and if he does, he may have missed the difference between equity and quasi-equity (that is to say convertible debt). He also may want to have a perspective on the returns of both instruments, their default rate and how their potential bias. I don’t see mezzanine in small buy out, for instance. That’s quite important. And there even was competition from second lien (ie, mezzanine rank as for debt repayment, not convertible in equity) at a certain stage. I am not sure that mezzanine investors are that busy at the moment. Maybe sponsorless mezzanine deals? Small and mid market LBO investors seem to continue to work, according to industry statistics (EVCA or national associations).

8. The paper does not differentiate the investment styles
Are we talking about lead investors or co-investors? Are we talking about syndication prone investors or sole investors? That makes a difference in evaluating the structures and hence the index validity.

9. The paper does not address the corporate governance issue
One of the reasons investors invest in private equity is not only returns and possible diversification, but also co-investment opportunities, access to knowledge and expertise, and the ability to exercise a corporate governance which is quite well defined. In particular, a fund manager cannot invest with one of the subsequent funds that he manages in the deals that would have been made with a previous fund – and this to avoid conflicts of interests.

Actually, one of the main concerns of listed private equity is that it is not reducing the principal-agent problem, but increasing it. Alignments of interests are reduced, as the managers do not face the regular sanction of a fund raising. They have a structure providing fees that they are mainly defining alone, and they have a pool of capital they can tap in without the same effort than with their private vehicles.

That is probably why KKR, Blackstone and the likes are salivating as regard to a listing: no annoying LPs doing their job and trying to reduce the fees you charge and asking difficult questions about the dogs in your portfolio.

10. Critics against unlisted private equity
There are mainly three, which can be discarded:

> Difficult access to fund managers and high minimum investment > can be solved with the help of a consultant, which can tailor a program or set a feeder fund for high net worth individuals. However, segregated accounts are better than pooled money, as they avoid the consequences of defaulting LPs and it is possible to negotiate a precise investment strategy.

> Illiquidity and fixed time horizon > history have proved that illiquidity can be a barrier against stupidity. By preventing massive retraction of the portfolio, it is possible to preserve a certain stability necessary to invest in the mid to long term. The partial sales of 3i and LGT’s Castle portfolio shows that listed structure are not immune from that – unlisted private equity is, at least if limited partners do not default. In that event, secondaries are still a possible way out.

Does this apply to the retail investor? No. The fact is that either retail investors should shoot for tax-efficient vehicles (such as FIP and FCPI in France) and get their immediate tax rebate by investing in a closed-end fund, or avoid private equity if they cannot afford to leave their money for a certain time at work.

Conclusion

So is there an interest in listed private equity? I would say no, unless you can « short»  the structures. This is not addressed, but could make sense. It is not possible to do that in the private world. Actually, to balance a portfolio, and manage the overlap between public and private equity investments, it would be good to use the public part to actually capitalize on the trends downwards, notably when the cycle is turning to a recession. However, I am not sure that the listed structures would really like this idea.

No because:

> investing in an evergreen fund is not satisfying as there is no way to improve the corporate governance, act on the fees which are charged and negotiate the rules of investments. Cash management is poor, there is a permanent discount on NAV of the portfolio, the liquidity is fluctuating and the choice of managers is low.

> investing in a fund management company is a ripe, mainly because basically the managers control the expenses which are their salaries and bonuses. They can increase them as they wish, and the income streams are either management fees or carried interest. Basically, you get the crumbles as an investor.

> investing in a holding combining fund and management company is even worse as there is a pool between the money used for expenses and the money used for investments.

Maybe the real reason of the existence of listed private equity comes from the fact that until some recent evolution in pension investment rules, unlisted private equity was out of reach. To give them some sort of taste of what it would be, fund managers set up structures which were listed. However, as they were uneffective, listed private equity stagnated until it was ignited again by the succession issues in fund management companies and the BO bonanza. It will probably go back to its desert soon.