Why is private equity so expensive?
Because it’s worth it, Mike Forestner, Mercer head of private markets, told the group’s NZ conference last week.
Forestner said private equity was “complicated, expensive and governance is a challenge” but – if well-implemented – the asset class could outperform public shares by 3 per cent or more on a net basis.
“Operationally private equity is intense – your back-office staff will hate you, your auditor will hate you,” he said.
And private equity, which is about 90 per cent correlated to listed shares, doesn’t offer much in the way of diversification, Forestner told the 160-strong Mercer NZ crowd.
“The real reason to invest in private equity is for high returns… There’s no way to ‘shoot for the middle’,” he said.
Even over the worst rolling 10-year period for private equity, the asset class performed ahead of listed markets, Forestner said.
But he said getting the best out of private equity required a clear plan and “relentless” discipline in how investments are implemented.
Mercer divides private equity into the four basic “building blocks” of buyouts, venture capital (VC), special situations (such as distressed debt) and “secondaries”. The final category, which refers to secondary markets, really represented a way to access private equity (sometimes at a discount) rather than a distinct investment strategy.
Within each of the three main private equity sub-classes, Mercer looks for skilled managers exposed to growth markets. For example, he said VC firms – such as The Column Group – playing in “life science” and IT (including big data, artificial intelligence and gaming sectors) markets were in favour.
The Column Group, one of Mercer’s underlying managers, invests in early-stage drug companies across 10 disease ‘platforms’.
In the buyout market Mercer prefers managers who can “make good businesses better”, Forestner said, with a focus on the software, financial services, healthcare and consumer markets.
While traditional consumer businesses were under pressure, he said there was still considerable potential in the market.
“People will spend money on unusual things if they’re marketed to well,” Forestner said.
He cited Genstar Capital as one of the standout buyout managers in the Mercer portfolio. The US-headquartered Genstar, which specialises in financial services and software firms, has made 16 acquisitions over the last three years, driving underlying revenues of the purchases by an aggregate 70 per cent with an expected capital return of 300 per cent.
“You won’t find opportunities like that in public markets,” Forestner said.
Mercer currently has just over 20 managers in its private equity portfolio out of a potential universe of about 600. He said private equity investors need strong discipline across portfolio planning, construction and implementation.
For instance, private equity requires investors to plan for a “constant flow of capital” across time-frames of five years or more.
Investing a one-off lump sum or cutting investment flows mid-stream could lead to “less than optimal outcomes”, he told the Mercer audience.
“You need a roadmap to get you through,” Forestner said.
A good private equity roadmap includes regular navigation points where investors review the actual portfolio against target allocations and metrics such as sector and geographical exposures.
The biggest danger for private equity investors was allowing “complacency and boredom” to push them towards riskier assets just for the hell of it.
As a rule, NZ investors have little exposure to global private equity but in the US institutional funds of US$600 million or more would commonly have about 15 per cent of their portfolios in the asset class, according to Forestner.