Philip Middleton examines the case for investment companies as against limited
partnerships
The vast bulk of money invested in private equity funds today is in the form of limited partnerships, or LPs. However, there is another structure used for private equity investment – the closed end investment company. Here, the company has a capital base which it invests. Investors do not own direct stakes in the underlying investments. Instead, they own shares in the top company – the investment company.
To understand the pros and cons of investment companies and partnerships, you have to look a bit more closely at how investment companies operate.
An individual LP investment has a standard life cycle. When the VC has found a suitable investment, funds are drawn down from the limited partners, each of whom owns a direct participation in the investment. When it is sold, the partners receive the cash. With an investment company, when an investment is identified, the company itself takes an equity stake. When it is sold, the company receives the cash. This money is then available to be invested again or “recycled”.
As a result, whereas LPs have limited lives, typically investment companies do not. LPs invest their committed capital, and return this to investors as deals mature. Because investment companies do not have to return capital, they can carry on ad infinitum, investing, realising and reinvesting.
Another key difference between LPs and investment companies is that with the former, once you have committed to a fund, you may find it hard to change your mind. There is a market in “secondary participations” in LPs, but this is not especially liquid, working on a willing buyer/willing seller basis. Investors in investment companies, however, can decide to sell their shares whenever they choose. If they wake up one morning and decide, say, that they want to reduce their exposure to private equity, they can in theory do so with a couple of phone calls.
The same is true in reverse. If an investor wants an increased exposure to venture capital, by buying an investment company specialising in private equity, they can achieve this at a stroke. For sure, they could also commit to a fundraising of an LP, but there is bound to be a significant time difference between deciding to commit to a fund, and seeing cash put to work.
This may all sound too good to be true. Investment companies allow you do increase or decrease your exposure to private equity through the quoted marketplace. No fundraisings, no wait to get invested, just a quick call to your broker is all that is required.
“Where’s the catch?” Well, there are two consequences of the structure of investment companies that not everybody approves of. Firstly, you can buy and sell your shares at will. However, there is no guarantee that you will be able to buy or sell at a price you like. With investment companies, as with any quoted share, the buying and selling price are simply the levels at which the market will clear. They do not necessarily bear any relationship to the underlying asset value of the fund.
To those who like investment companies, this is an advantage. Sometimes, you can pick up bargains. The chart shows the price and asset value of Schroder Ventures IIT, one of the larger UK listed investment companies. Over the past year, the price has appreciated by significantly more than the asset value. For the first thirty months of its life, the reverse was the case. In other words, LPs are free from secondary market pricing risk, whereas listed investment companies are not.
Also, although when you buy an investment company, you may be gaining 100% exposure to private equity (indeed, some use leverage to obtain an exposure of over 100%), you may also find significant cash levels. This tends to be a problem of success. If an LP turns £1 into £10 for investors over a year, it simply writes the limited partners a cheque for £10, and everybody applauds. If an investment company does the same, it suddenly has an extra £10 to invest.
It does not do to overstate this objection for two reasons. Firstly, it may well be that the alternative to buying an investment company with 30% cash in its portfolio is investing in a fund when the first investment is some months away. Secondly, in theory at least there is little difference between an investor holding cash against future calls and an investment company in effect doing the same.
Finally, whereas LPs seem to have a relatively standard fee structure, investment company fees are far more variable. Some mirror LP practice, some funds charge flat fees only, some funds charge no fees but employ the investment executives directly.
In short, it is not so much a question of investment companies or LPs being “better” vehicles. They simply suit different investors, with different needs and preferences. Also, as is so often the case in life, the good points in one structure tend to lead to its bad points and vice versa.
This may not amount to a conclusive proof that investment companies are the future of private equity investing, but it does, in my view, suggest that investors should seriously consider the investment company option when building up a private equity portfolio.
If you buy this argument, the next step is to look at the individual companies. The single biggest group of venture capital funds are the UK listed investment trusts. The table sets out the larger of these.
Few things would delight me more than to have the chance to describe at length the attractions of each of these companies, but sadly, space does not permit this. A brief thumbnail sketch of the larger of these, though, may be in order.
q 3i is the UK’s largest venture capitalist, with a significant and growing European business and a very material global technology operation. At the end of September 1999, for example, it had over £1.1bn invested in technology. The company also benefits from the carry on 3i’s third party funds.
q Electra, unusually, is in the process of returning capital to shareholders through a series of tender offers for its shares. It is not, at present, investing in new deals, although it is considering giving investors the option of a continuation vehicle.
q Schroder Ventures IIT is the most global of the companies, providing a balanced exposure to Schroder Ventures worldwide deal flow.
q F&C Enterprise specialises in medium to smaller deals, and has recently taken powers to invest in quoted equities.
q Candover is somewhat unusual, in that as well as a portfolio of private equity, the company benefits from the carry and fees earned on Candover’s third party funds, which are very much larger than the investment company itself.
q JZ Equity Partners invests in medium sized US deals.
Investment companies may not suit all of the people, all of the time, but many of them have delivered strong medium term returns, and their structural features give them at least some key advantages over LPs. I believe they are definitely worthy of your taking a long, hard look.
Philip Middleton is an investment company analyst at Merrill Lynch. Merrill Lynch is corporate broker to 3i Group and Schroder Ventures IIT

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