Research

Alternative investments

Many investors think successful private equity investments offer far better returns and significantly diversify their share portfolios. The reality is vastly different. While good returns can be achieved, they are the exception, not the rule. And the benefits of using private equity to diversify a portfolio are not huge. But if these limitations regarding private equity investments are recognised then they can still be a small but important part of a share portfolio, public and private.

What are private equity investments?

Private equities are unregistered shares in public and private companies. They are not traded on the sharemarket. They are found in venture capital funds (offering shares in private businesses in their early stage of development), buyout funds (offering shares in more established companies with positive cash flow) and mezzanine funds (offering shares just before a public listing).

How are the returns measured?

The very nature of this asset - no market value - makes it difficult to measure the returns for this asset class. This is one of the biggest problems with private equity investments. Before there is an IPO (initial public offering) or the company is valued when it is privately acquired, only the manager of the fund holding the investment can put a value on it. This valuation, by definition, must be subjective to a degree. Only an IPO can put a real market value on the investment.

Guidelines have been established to evaluate the net asset values (NAVs) of private equity investments. But NAVs will inevitably be distorted. For example, putting a value on any goodwill in a private equity investment has to be subjective.

To overcome the subjective nature of NAVs two measures have been devised to measure returns - internal rates of return (IRR) and distribution to paid-in ratio (DPI). Both have their limitations. IRR can only be used to measure the competing returns of private equity investments. They cannot be used to measure the performance of private equity investments against shares listed on the sharemarket. DPI -defined as total distributions (dividends) divided by the total capital invested - does not give a time value to either the distribution or investment. In other words, $1 invested today is viewed the same as $1 invested 10 years ago. The effect of inflation on the investment is discounted.

IPOs: Potentially, the missing link

Typically, the handsome returns that private equity investments can deliver occur when they become listed companies. This return usually far exceeds the dividends private equity investments deliver to investors. The best measure to show how the value of private equity investments can dramatically change on public listing is the instant return rate, the difference between a company's IPO offer price and its price at the end of its first day's trading. In the US, between 1985 and June 2002, the average instant return rate from venture capital IPOs was more than a staggering 300%. The result for buyout funds in the same period is far less impressive except for a period in the late 1980s. Quite clearly, it is investors who get in on the ground floor of a venture capital project who stand the best chance of making a handsome return.

Private equity: minimal benefits from diversification

Supporters of private equity investments frequently extol its diversification benefits. They argue that a diversified equity portfolio should have small percentage invested in private equities, balancing the risk element against the potential for high returns. But these benefits of diversification are overstated for two reasons: the low level of liquidity in many of these investments and, more importantly, the fact that the value of these investments can only be realised after a public listing. But public listings depend, in part, on how the sharemarket is performing overall. If the sharemarket mood is bearish, investors often shy away from IPOs, making it harder to bring these investments to the market to unleash their potential value. For these reasons private equity investments should be a small element of an equity portfolio.

Other negatives

Private companies are not subject to the same degree of public scrutiny as their publicly listed counterparts.

The potentially enormous returns that IPOs offer investors in private equity investments are also tempered by the fact these investors can have limits placed on when they can sell their shares, either by the company or a regulatory body. And even if there is none or little limitation on this selling, the market is often wary that these investors will dump their shares and depress the price.

On a longer-term time horizon research shows that venture capital companies underperform major sharemarket indices. In the US, the home of venture capital companies, a key index for these stocks, the Post Venture Capital Index, consistently fails to match three key indices: the Dow Jones Industrial Average, the Standard & Poor's 500 Index and the Nasdaq. Indeed, one study shows that the five-year return of new companies was a staggering 44% lower than a group of companies with similar market capitalisations that had been listed for the previous five years.

The negatives are not limited to market performance. Private companies are not subject to the same degree of public scrutiny as their publicly listed counterparts. The degree to which the boards and managements of the latter have to explain any decision that could "substantially" influence their share price is a world removed to the privacy afforded private companies. It is this lack of market knowledge, when coupled with the inherent illiquidity of private equity investments, which makes them such a risky proposition.

More specifically, this lack of information about private companies reveals itself in six key areas:

• A higher risk of bankruptcy. In the event of bankruptcy, there is little likelihood of investors recovering their investment.
• Lack of liquidity.
• Limited opportunity to reinvest dividends in a private equity investment.
• The potential for conflict between the owners/managers and investors.
• Lack of information about these investments.
• Difficulty in "smoothing out" tax liabilities.

Private equity funds: A safer option

Many investors choose to minimise the risks involved in private equity by using the services of funds that specialise in this sector. These funds take large stakes in private equity investments, as well as having an active role in monitoring and advising the private companies in the portfolio. There are three benefits from this approach:

• By spreading private equity assets across different fund managers and different sectors investors limit the risk of getting the wrong manager or sector.
• It reduces the risk of bankruptcy as these fund managers should be better placed to evaluate the performance of the portfolio companies.
• It often provides cheaper access to private equity investments.

But there is one major disadvantage: cost. These funds typically cost investors more that their listed market equivalents for the obvious reasons of their higher risk and greater expense in gathering and analysing information about the portfolio companies.

Summary

Private equity investments can realise enormous returns. But they can be difficult to measure, project, and, most importantly, realise. These are not arguments to ignore this asset class; it is an argument to approach it with extreme caution.

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