Recovery Time

As a new marketing campaign for private equity investment trusts gets under way, Paul Farrow examines whether, with mounting cash reserves, the sector will continue to outperform this year or is about to pause for breath.

Private equity has been the talk of the City over the past year but has been overlooked by private investors and underused by institutions.

Only last week, Britain’s biggest pension funds were being advised to increase their investments in private equity deals. Leading actuarial consultants such as Mercers estimate that pension funds that hold private equity tend to keep their investments down to 3% of assets. This is insufficient, they say, believing that the proportion for some funds should be up to 10%.

Several investment trusts argue that private investors should also increase their exposure to the asset class. Putting the ill-fated “Its” campaign behind them, several trusts have joined together in a bid to raise the profile of private equity investment trusts.

Some analysts blame the lack of transparency for their current unpopularity. Peits are valued only twice a year and are only required to use one of five valuation methods laid done by the British Venture Capital Trust Association: cost, earnings multiples, an imminent sale price, the price of a recent investment, or net assets such as may exist for property companies. But many trusts argue that the main reason for the neglect of Peits is that they are all too often confused with venture capital trusts and lose out as a result.

“For us, private equity encompasses all aspects of investing in unlisted companies, including buyouts, venture capital and development capital, as well as mezzanine,” says Neil Sneddon, a director of F&C. “Venture capital involves investing in younger companies at an earlier stage in their development.

“Companies are usually cash consumptive rather than cash generative and, as a result, are usually not geared. The return potential is higher than buyouts but there is also higher risk of failure and capital loss, so to be a successful venture capital investor you need your successes to more than compensate for your failures and the additional risk you are taking. We invest in both buyouts and venture, to a lesser degree.”

Ross Marshall, managing director at Dunedin Enterprise, says: “We invest in established businesses, unlike venture capital, which invests in early-stage start-ups. We are backing the incumbent management team and we look to grow organically, bolt on acquisitions and roll out new outlets. The sector is less volatile than it was 20 years ago, when private equity was all about taking minority stakes in small businesses. Now we take majority stakes and can take action if things aren’t going well.”

Marshall points to Dunedin’s investment in Goals, a leading operator of “next generation” five-a-side soccer centres. The trust led the management buy-in back in 2000 and subsequently provided further development finance, allowing the business to expand from five football centres to 11. It had doubled its money when the trust exited the deal in 2004, when Goals floated on Aim.

Most Peits invest directly in unquoted companies but some are structured as funds of funds. Several Peits also act as fund managers, managing third-party funds as well as the Peit, which is a factor in their rating. There are geographical variations too, with Peits that invest in Britain, Europe, America and globally. Some also have industry sector specialities. They cover a range of strategies including management buyouts and buy-ins, development capital and replacement capital.

Andrea Lowe, who has been given the task of heading the private equity investment trust sector marketing initiative, says that Peits give investors the opportunity to access some of the most highly regarded private equity managers in Europe, which would otherwise be out of reach.

“Larger investors including family offices, pension funds and other institutions may also have reasons for wanting a more liquid, quoted vehicle for this increasingly popular asset class,” she says.

The move to raise the profile of Peits comes at a time when the private equity sector is booming. Last year, the total value of the European private equity market exceeded 125bn (86bn), an increase of 40% on the previous year’s 89.8bn. The trend has been borne out by Peits. Private equity is the top-performing trust sector over the 10 years to the end of 2005, up by 338% on average.

Naturally, such stellar returns have fuelled concerns that the sector will pause for breath. Early signs that the bull run may be checked have emerged in the past month. The British management buyout market recorded its lowest quarter for two and a half years in the first quarter of 2006, according to figures released by KPMG’s corporate finance practice tracking British buyouts with a value of more than 10m. It says that 31 transactions with a total value of 2.9bn were completed in Britain in the first quarter of 2006, compared with 35 deals totalling 6.3bn in the previous quarter.

Other experts are concerned about the motives of some private equity groups and the quality of deals. The International Monetary Fund hasthrown its weight behind growing concerns over debt levels and warns that leveraged buyouts by private equity funds using a high degree of leveraging have significantly weakened the credit quality of the targeted companies.

In its twice-yearly assessment of risks to global financial stability, the IMF singles out a shift in the behaviour of private equity funds that has increasingly seen them load up with debt companies that they buy out to extract early dividends for their investors. There is also concern that a lot of the debt being raised is syndicated by hedge funds, rather than quality investment banks, which could have a negative impact if hedge funds are forced to sell the debt (at a lower value) for one reason or another.

“It could be a potentially dangerous situation in difficult times,” warns Tim Syder, a director at Electra Partners.

Justin Urquhart Stewart, marketing director at Seven Investment Management, has no doubts that the quality of deals is deteriorating and questions whether private equity continues to have the “fashionable consistency of an Yves St Laurent”, or becomes just an “embarrassing kipper tie”.

“For some, private equity is just the proper functioning of a capitalist industry, where investment money is deployed to seek out undervalued companies, and often indifferently managed assets, and improve the effectiveness and success of the targeted companies,” he says. “In many cases over the years, there have certainly been some very successful turnarounds, where ailing companies who had lost their way were refocused and returned to the market a far sharper and brighter business than when they left.

“However, we have started to see more deals being proposed not just to release shareholder value, or increase balance sheet efficiency, but rather to buy assets, break them up and flog them off. Additionally, there are others where it has been proposed to buy the business, load its balance sheet with far larger borrowings and pay the extra cash back to the new owners. Now, does this really increase the effectiveness of the business? Or does it just weigh the company down with the extra cost of more debt and thus reduce its ability to expand in the future?

“Such rabid behaviour in the past went by a far less attractive title, which few ever dare repeat today: asset stripping. These more aggressive adventurers may be seen in the same light and, far from being just private equity or venture capitalist, should be regarded as vulture capitalists, feeding off the flesh of their prey, leaving not a healthier beast but a pained and wounded one.”

Whether Urquhart Stewart’s well-versed doomsday scenario comes to fruition is debatable, say the Peit managers, who are adamant that higher leveraging will not affect all Peits. They argue that the sector is diverse and many trusts focus at the lower end of the private equity deal table – under, say, 100m.

“The level of gearing is significantly less among the smaller deals, plus the structure of the loans is less complicated,” says Richard Green, managing director of August Equity Partners’ Kleinwort Capital Trust. “In a 50m deal, you may borrow 25m from one bank, but in a big MBO, the debt could be as much as 80% of the deal, with several third parties and banks, and complex loans with different levels.”

Sam Robinson, director at SVG Capital, reckons it will be the poorer managers that will get caught up in the excessive borrowing trap but fears that a prolonged period of higher prices could put many trusts and private equity funds under strain to embark on deals they may otherwise ignore. “Certainly leverage has gone up, as have the prices people are prepared to pay,” he says. “The prudent are prepared to wait, but there is only so long they can sit on the sidelines.”

By their nature Peits are cyclical, slow-burning investment vehicles. Because they have generated substantial returns over the past three years, such performance may not be repeated in the short term. The bumper deal season has left many trusts awash with cash and some analysts have highlighted that funds investing in private equity are struggling to invest the cash generated by buoyant M&A and debt markets. High cash levels can dilute returns because that money will only generate 4-5% returns, compared with the much higher return expectations of private equity. Experts say that more than 50% cash is a worry and may lead the manager to consider ways of returning excess capital.

It is indicative that the selling or realisation of companies changes a Peit’s valuation and assets. As Lowe points out, ironically, it can also bring a burden, since the proceeds of this realisation have to be retained within the trust, rather than distributed to investors, which would trigger a capital gain.

“Cash staying in the trust until a new investment is identified can be perceived as a drag on performance in rising markets since it is not actively invested,” says Lowe. “Frustrating to managers, this cash position can lead to demands to return capital, particularly in nervous markets, when investment conditions may be at their best. However, the sector’s repeated outstanding 10-year performance has been achieved when most Peits have carried significant cash drags.”

Several trusts have made exits in recent months and are subsequently sitting on significant cash levels. Many are now looking to return cash to investors.

For example, Candover’s returns had been diluted by high cash weightings for several years, while in 2005 the company invested 41.7m and realised assets of 100.8m. By the end of March this year, more than half of its assets were in cash. It recently announced plans to return 100m in cash to shareholders, equivalent to 457p per share. The planned deal would put the trust on a premium of around 30%, which experts say is justified given its track record.

Candover is not alone. Next month, the granddaddy of the sector, 3i, will reveal how it plans to return 500m to investors, while Caledonia Investments plans to return up to 125m, and Prelude 5m.

Chris Oakes, an analyst at ABN Amro, uses levels of cash and fixed income holdings in the trust to estimate the timing of future returns. “High levels of cash and fixed income, as the result of a series of disposals, are not unusual, and currently some of the trusts have more than 40% of their assets in cash and gilts,” he says. “In the short to medium term, this cash will need to be invested, and since new investments can be valued at cost for up to 12 months, we can assume that this portion of the trust’s assets will remain effectively unchanged over the short term.”

But the analyst team at Wins Investment Trust warn that new investors should be wary of high cash levels in some trusts. “Realisations are at record levels, through trade sales, IPOs [initial public offerings], secondary buyouts and recapitalisations, whereas attractive investment opportunities are harder to find following a strong rise in share prices in the past few years and abundant liquidity in the private equity market,” says Simon Elliott, an analyst whose core recommendations in the Peit sector are HG Capital (“greater exposure to Europe where there is value than its peers”) and SVG (“excellent long-term record”).

Many trusts are, not surprisingly, at pains to play down the high cash level story. They argue that whether cash is a problem depends on the concentration and how long the cash balances stay high. “Trusts with new portfolios will take 18 months to see any real value, while those with old portfolios will take two to three years to drawdown any value,” says Robinson. “But I don’t think we will see a repeat of last year’s growth. A lot of good companies have been sold and it will take time to get another good crop. The key, as with any investment, is often the manager. You can still make money in poor times.”

Kleinwort’s Green argues that having high cash balances comes with the trade and is often a sign of success. “It is not disastrous having cash balances – the sector goes through cycles and it is a very attractive exit environment at the moment,” he says. “It is better to have cash than nothing – at least it is a solid investment.

“You can’t have a good entry and good exit environment at the same time. Trusts have built up cash balances and that money will take time to deploy, but it is sensible to wait for the best deals.”

Peits deals

Filofax Do you remember Filofax, the must have accessory of the 1980s? Investors in Dunedin Enterprise will. Dunedin initially invested in Letts in 2000 when it supported the 17m management buyout. Less than a year later, Filofax was acquired for 14.5m. Dunedin supported the acquisition soon after the initial MBO, recognising that consolidation of the Letts and Filofax brands would bring “attractive synergies”. The business was sold in March 2006 for 45m to Phoenix Equity Partners in a secondary management buyout, returning a six times money multiple and a 52% internal rate of return over five years.

Paddy Power Paddy Power is Ireland’s largest chain of bookmakers, which pioneered internet and telephone betting. Hg Capital Trust invested in the company in June 2000. A little over four years later, it sold its final tranche of shares, resulting in a total profit of 2.6m and a compound annual rate of return of more than 70%.

Gala Bingo Candover’s partial realisation of its equity holding in Gala, the bingo and casino operator, crystallised a cash return to date of 1.3 times the original investment. It retains a stake. Under the terms of the transaction, Candover sold an equal amount of equity to funds advised by Permira, which has invested 200m to become a joint and equal owner of Gala alongside Candover and Cinven, which originally backed the 1.24bn buyout in March 2003.

Peit recommendations

John Newlands, former Williams de Broe investment trust analyst and founder of Newlands Funds Research, makes the following recommendations in Scrutineer, his company’s private investor newsletter.

3i It used to be said that a company’s computer buyer would never be criticised if they bought IBM. They would never be the cheapest machines in the market but they would always be in the premier league for reliability and overall performance. 3i is the IBM of the Peit world. Make no mistake, 3i is a quality multi-billion pound company, with expertise across all funding stages, from start-ups (in the 1m to 10m range), through growth capital (10m to 100m) to buyouts of virtually all sizes.

The most obvious apparent downside is the substantial premium to NAV of 32%. These sorts of figures can be misleading for Peits, though, as their balance sheets can contain hidden value that can suddenly be released. On February 13 this year, for example, 3i made 3.4 times its money on the sale of WiIliams Lea, the print management group. The proceeds of 110m represent an uplift of 86% over the balance sheet valuation and added 9.3p to the NAV at a stroke. This is the kind of good news that investors like, might expect from 3i under its rejuvenated management team, and are prepared to pay a large premium for.

Dunedin Enterprise This trust run by Dunedin Capital Partners aims “to invest in 10-50m management buyouts and buy-ins”. Appropriately, DCP, which is an independent private equity house owned by its directors and staff, was itself a management buyout from Dunedin Ventures Limited in Edinburgh a decade ago. Although the trust may not be as well known as 3i or Candover, its management team is far from inexperienced. Chief executive Ross Marshall is PriceWaterhouseCoopers trained and spent 10 years with 3i. He has been involved in more than 30 management buyouts and buy-ins over the past 20 years, including leading the MBO of Dunedin in 1996.The trust has outperformed the FTSE All-Share index over one, three and five years, and its team has a reputation for its meticulous approach and rigorous analysis prior to investment. Dunedin Enterprise has moved to a small premium recently as its strengths have been recognised by the market.

Hg Capital Ian Armitage, another manager with 10 years before the 3i mast, has led Hg Capital since 1990 and has made investments across a wide range of industries, including the buyout of NTL. HgCapital is the successor to Mercury Private Equity. The trust was acquired by Merrill Lynch in 1997 and bought out in turn by Mercury Private Equity staff in December 2000. Hg Capital invests in six sectors: consumer, healthcare, industrials, leisure, media and technology. The trust has been a solid performer over a decade or more and although HGT stands at a premium, its proven ability to deliver returns from its sector makes it an attractive choice.