Should private equity go public?

The development of a listed private equity market and the creation of private equity indices are changing a traditionally seen opaque, long-term asset class. Maha Khan Phillips reports

When US buyout giant The Blackstone Group decided to go public last year, it raised eyebrows in the private equity industry. Participants, particularly other houses that were considering such a move, decided to watch events closely to see how the company would do.

It was clear almost immediately that there were pitfalls to opening private equity to the public markets. Three days after listing in June, Blackstone's share price closed below its offering price. Now, almost a year later, the share price has more than halved from its peak of $38 (€24) per share. Unfortunately for Blackstone, the company's listing came only weeks before the credit crisis began. Suddenly, going public didn't seem all that great an idea.

"People got excited at the time that Blackstone was listing and the whole private equity going public theme was a big issue," says one consultant. "Now, people are more focused on market conditions, and this is off their radar."

Still, managers say there is room for private equity in the public arena. LPX, the Switzerland-based private equity index provider, estimates the industry as a whole to be worth €1-1.5trn. The listed market stands at about €90-100bn, or roughly 10% of the total.

There are many ways of going public. A private equity firm can either list publicly as a quoted public company, or launch an investment trust. "Going public is sometimes a way for a founder to exit the company," explains Sanjay Mistry, head of European private equity research at Mercer. "It providers owners with a release of capital."

Ed Francis, (pictured right) senior investment consultant at Watson Wyatt, believes that going public can also have an effect on a company's dynamic. "Investors have to consider what impact being public has on culture," he says. "It's all very well when things are going well, but not when things are going badly. The concern is about what being public and being accountable to external shareholders does to you as a firm and culture and the way you treat your limited partners."

The most obvious benefit for a manager that lists is access to so-called ‘evergreen capital', according to Francis. An investment in a listed vehicle, unlike a partnership, has no fixed lifespan and therefore is not distributed back to the investor when an investment is sold.

"This is the ‘Holy Grail' for private equity and hedge funds alike as the proceeds from the sale of assets are retained for re-investment, allowing the manager to re-invest continually," Francis explains.

He believes clients should be wary. He argues that investors may be uncomfortable with some aspects of fee charging, particularly the recurring stream of fees, because these may affect a manager's incentive. "The net and gross asset values on which fees are based are generally calculated twice a year, and the values of unrealised investments will only be estimated. This could potentially tempt the manager to choose a sub-optimal exit strategy," says Francis.

Critics also point out that listed vehicles do not behave like private equity. "We don't particularly use private equity vehicles," says John Gripton, (pictured left) managing director and head of investment management at Capital Dynamics, the $20bn manager that has invested in over 550 private equity funds. "Listed vehicles can hold large amounts of cash that only earns a fixed interest rate of return, rather than a private equity return. As a result investors see their private equity returns diluted."

He also argues that valuation of the underlying assets is also a difficulty. "Many of the quoted vehicles trade at a discount to net asset value. With an asset that is already being valued at a very conservative level, you end up realising your investment with a double discount."

Others are quick to point out that listed vehicles do not provide access to underlying assets, and as such are too closely correlated with equity markets and less so with private equity.

Research by Watson Wyatt has shown that the recent dislocation in credit markets has significantly shifted market sentiment on the ability of private equity firms to generate value (see illustration). Prior to the credit crunch, the well-developed listed private equity sector in the UK did not have to trade at a discount to net asset value. A comparison of where several securities were trading on 30 November 2006 and 8 January 2008 reveals just what a difference the current market has made.

The hardest hit on the table, SVG Capital, declined to comment on net asset value. However, Peter McKellar, (pictured right) CIO for private equity at Standard Life Investments, which has also seen its NAV affected, says this is a long-term game. "Anyone coming into listed private equity should be coming in for the longer term. On the whole, listed private equity has outperformed equities and generated strong absolute returns and there have only been a few occasions where they have generated short period negative returns, particularly for those vehicles that have a more generalist strategy."

He also argues that the listed marketed offerings liquidity and pricing opportunities that resonate with small institutional investors who cannot be tied into illiquid assets, "particularly to defined contribution pension funds. It also appeals to family offices and high net worth discretionary fund managers."

McKellar dismisses arguments about indirect access being pointless. "The underlying assets are private equity funds, and accordingly there is a diversifier against traditional equities there."

Meanwhile, retail and high net worth investors are also accessing private equity through indices. LPX, the first private equity index provider, was launched in 2004. Since then there have been a plethora of players, including Standard & Poor's, State Street, Société Générale and Red Rocks Capital Partners.

"The impetus to launch came from banks and institutional investors that wanted a transparent private equity index," says Michèl Degosciu, (pictured left) founding director and managing partner of LPX. In order to be eligible, a company must invest at least 50% of its assets in private equity. "Or it could be a management company with responsibility for several private equity funds." LPX now offers 12 indices and sub-indices. Several investment banks have launched products off the back of them.

Elsewhere, the S&P Listed Private Equity Index trawls through all publicly listed companies in the Standard & Poor's Capital IQ (CIQ) database that engages in private equity businesses. S&P reviews the business descriptions and publicly available documentation and assigns a score. The universe is narrowed down to an investable set of stocks based on market capitalisation (stocks must have a market capitalisation above $250m), liquidity (they must have a three-month average daily value traded above the liquidity threshold of $1m as of the reference date of each rebalancing), volume (the stock must trade on average 10,000 shares a day for the year before the appropriate reference date) and listing venues (the stocks must be trading on a developed market exchange).

Critics say the indices make very little sense. "Putting the indices together is quite a difficult thing," says Mistry. "They all have potential issues whether they look at certain companies or exclude certain parts of the market. In some cases you may get a sub-set of private equity managers providing information to make up the index, so it may not be as representative as you'd like."

But John Davis, (pictured right) senior director, European business development at S&P's index & portfolio services, says they are missing the point. "We looked at private equity on a number of occasions and one question we had was whether we had the experience in due diligence and monitoring of the entire market, and we decided no. We tried working with external partners. In the end, we decided that instead of trying to build the perfect Fabergé egg, we would try to build something meaningful, and our decision was to go down the listed private equity route."

Although end users are primarily retail clients, Davis believes the index can also be useful for institutional investors. "Would pension funds look at our index in terms of asset allocation? Possibly not. But there are a number of certificates and a number of exchange traded funds listed again this, which may be of interest."

He accepts that accessing private equity indirectly is not perfect. "If you have the luxury of being able to get directly into private equity than you have an asset class that has a low correlation to traditional equity markets. If you go down the listed route you will have a slightly higher correlation, but at the end of the day if you believe in having exposure to that particular space and you can't afford to do it directly, this gives you a tool you can use."

But Francis remains to be convinced. "If I'm a fund management company and I think a listed private equity firm is good value, then I'll buy the shares. But that investment is not a good substitute for private equity as a broad asset class."