All private equity may look the same to outsiders, but it is not. Politicians and the press usually generalize and in reality focus on the most spectacular, read largest, investments, the “mega” buyouts with the occasional success story from venture capital, like Facebook. The graph below (source Preqin) is an over-simplification but illustrates that the returns of the different types of private equity... 

All private equity may look the same to outsiders, but it is not. Politicians and the press usually generalize and in reality focus on the most spectacular, read largest, investments, the “mega” buyouts with the occasional success story from venture capital, like Facebook. The graph below (source Preqin) is an over-simplification but illustrates that the returns of the different types of private equity are very different and that the risks are not the same either. The size of each bubble represents the size of the combined total of the investments made over the period of 2001 – 2011. The largest category,  buyouts,  represents  the  total  amount  of  $  1  trillion.  Early  stage  venture  capital  is  the  most difficult by far, with the lowest returns and the highest risk, measured as the standard deviation of returns (Internal   Rate   of   Return).

Early stage venture is liked because of a  cuddly  image of  young  college  drop-outs starting the next Apple in a garage.   The    amounts   are also relatively small, which is why novice investors often make the mistake  to  start  with  early  stage venture. The reality is that it is by far the hardest of all, because so much is unproven. The entrepreneur is likely to have very little or no business experience, the technology may not exist yet, the market will be very small and be both fast growing and fast changing and the value is created by growing the company very fast from a few people to hundreds or even thousands. Even the most experienced managers would find this difficult, leave alone someone without much experience at all. Later stage venture is bigger and as the name says, at a later stage of its still very early development. Later stage ventures and its management will be more mature, technology will be less of an issue and the business has become much more predictable than early stage which may not be much more than an idea or a prototype. This higher certainty is typically priced in, but on average later stage venture has generated higher returns with less risk. An interesting phenomenon is that when there is little money available for venture capital, investors migrate to later stage and when more funding is available there is a shift to early stage. Buyouts and private equity are often mixed up, as most of the money invested in private equity ends up in buyout funds. Mature and usually steady and profitable companies are bought from shareholders who want to sell. This can be from a corporation that has decided that an activity is no longer “core”, or from a family where there is no obvious successor to the founder or owner/manager. These kinds of companies tend to be in slow moving markets and are usually profitable  and  predictable.  Whereas  an  excellent  venture capital deal may generate 100 times the original investment, such cases are highly unlikely in buyouts. Buyouts are investments in relatively boring and slow moving business. A good buyout will have been done at a good price after which many small improvements have been made to the business. This in turn is then amplified by leverage, borrowing more than half the required sum, which amplifies the return on investment. A very good buyout will pay its investors 3 – 5 times their investment back. Because the failure rate of buyouts is low, the average return is better than average venture capital. To the right of buyouts with slightly better return is a small category of distressed private equity. These are often failed buyouts and have a similar profile. A buyout may have had too much debt and needed a restructuring of its balance sheet. Equity holders will usually lose  most  of  their  investment,  whereas  debt  holders  will either convert their equity or work with a new shareholder, the distressed investor, who may even acquire some of the debt at a discount. Often this is accompanied by operational restructuring (turnaround). The press regularly gets this wrong and equates buyouts with turnarounds. Most buyouts do not  have  this distressed character and are healthy and sound businesses. An interesting and very large example of a buyout gone wrong is that of the largest buyout ever, TXU and subsequently named  Energy  Future Holdings. It went bankrupt not because of the massive amount of debt ($ 40 billion); the investment failed because it was really a bet on rising natural-gas prices, just before shale gas got going. Electricity rates were linked to gas prices and unfortunately for TXU, natural-gas prices plunged as hydraulic fracturing of shale rock unleashed a glut. The highest average returns over the 2001 – 2011 period were made  by secondary transactions, whereby a secondary investor acquires an illiquid private equity position. The advantage of secondary investing is the ability to shorten the period the investment is held and to buy into investments that are already known. Often but not always, this can be done at a discount to the “real value”. The discount depends on the pressure the seller is under and on the supply of money chasing the available deals in the market. Returns, measured as Internal Rate of return (IRR), for secondary transactions have been close to 15%. As holding periods are relatively short it is rare to make more than 2 times an investment, but is also very rare to lose money on a secondary fund. The lowest returns, as well as the lowest volatility is found in mezzanine lending with relatively high interest rates and usually a so- called “equity kicker” sharing some of the higher return shareholders may get if things go well.

By volume buyouts clearly dominate private equity with a relatively good risk/reward profile. The best, secondary transactions and distressed investments are in many ways “left-overs” from buyouts and will therefore never be as large as buyouts.

 

Hans van Swaay
Partner
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