Buying global private equity, step-by-step

One year into building a global private equity program, alongside its advisor StepStone, an A$97 billion ($78.8 billion)Â Australian large multi-manager posted a booming 200 per cent return on the back of some fortuitous secondaries investments. Simon Mumme reports.

In its first year the Future Directions Private Equity Fund run by AMP Capital Investors (AMP CI) generated a headline return of 203.8 per cent and an internal rate of return (IRR) of 20 per cent, primarily due to its foray into the secondaries market.

Contrary to the experience of many secondaries investors, whose expectations of buying good assets cheaply from distressed sellers were largely unmet, AMP CI’s large commitments to the sector, representing up to 30 per cent of the $140.5 million it invested in private equity last year, paid off well.

“People say secondaries was the opportunity that never was, but secondary assets can produce results,” Suzanne Tavill, portfolio manager of the multi-manager product, says.

Tavill attributed AMP CI’s solid gains to the manager’s exposure to secondary assets of a “palatable” size – between $4 million and $12 million – which were sourced through StepStone, its private equity advisor.

Secondary assets are typically more mature than primary investments and therefore more likely to deliver higher returns sooner. Tavill says AMP CI targeted a long-term IRR of 15 per cent from the private equity portfolio.

The $78.8 billion Australian institution partnered with StepStone in early 2009 to build a global private equity program. In addition to its 30 per cent exposure to secondaries, AMP CI has allocated 5 per cent to co-investments and 65 per cent to primary funds. The manager aims to commit a further $140.5 million or so to private equity throughout 2010 and would not follow a similar allocation pattern, but respond to opportunities, Tavill says.

Tom Keck, chief investment officer with StepStone, says some of the largest challenges facing private equity managers were carefully deploying the glut of capital raised before the financial crisis – which resembled a “pig in a python” – and negotiating the “wall” of refinancing due in the medium-term future.

“Even though the wall is in 2014, people have to pay attention to it today,” Keck says.

The debt and equity components underpinning businesses will need to be restructured, resulting in debt-for-equity transactions and asset consolidation as companies sell parts of their business.

Lenders will feel some pain, the equity holders will experience more – “and that equity capital will require a fair amount of return,” Tavill adds.

Such refinancing headaches have motivated AMP and StepStone to focus on managers running small- and medium-sized companies applying small volumes of leverage as they attempt to implement operational improvements.

Keck is also concerned that the mass of capital awaiting investment could bid up asset prices in the near future, meaning that vintages from the global recession might not be so special.

“There will clearly be managers that have a lot of capital to put to work. As we talk to out managers they do express the concern that debt capital markets have come back more quickly than expected, and there are players out there bidding aggressively for assets.”

But he expects there to still be “pockets of inefficiency where broader capital flows won’t influence what’s going on”.

These could manifest as a company “with a little bit of hair on it” requiring capital and operational restructuring. He says investors can avoid inflated prices by seeking proprietary, or private, deals instead of attending asset auctions.

Exacerbating these problems is the outward appeal of almost every private equity manager. “Virtually every manager on the market has a top-quartile track record – somehow. It’s one of the things that makes private equity difficult,” Keck adds, particularly since there is a persistently wide dispersion between the best and worst managers in the market.

AMP CI’s preference for managers applying operational expertise rather than financial leverage restructuring has led them to China, where the nature of the private equity market is different to that in the US, Tavill says. One big difference is the scarcity of mega buy-out players.

Keck says Asian private equity surged after the debt crisis of 1997, when managers swooped on the numerous debt restructuring transactions taking place, but it wasn’t until 2004-05 that Chinese private equity managers demonstrated repeated success in their investments.

This was accompanied by a significant change in the government’s attitude towards private equity managers as it realised the ability of managers to bring management skills into the economy and reduce the government’s role in certain industries.

Not only did the government encourage global private equity firms to invest in China, it also supported domestic managers as they set up shop.

“To sustain its growth, China needs a tremendous amount of investment. But they also need management expertise. Private equity is a great way to restructure portions of their economy that [the government] wants to be more in the private sector than the public.”

He says the primary danger is the rapid expansion of China’s capital markets, and the ability of this momentum to warp asset prices and return profiles.

“You don’t want to rely on that for returns, but on operational improvement by managers on the assets they own.”

The theme driving AMP CI’s allocation to China is the growth of companies profiting from the burgeoning numbers of Chinese consumers.

“It’s logistics, consumer staples, industrial-types of businesses. It’s about manufacturing, providing goods and services to the emerging middle class. There is no high-tech aspect to it,” Keck says.

“We’re not out there trying to find the Google of China.”