LISTED PE: In Better shape

The outlook for listed private equity is healthier than it has been for some time. So why aren’t more investors buying? And is there anything managers can do about it?

It’s a drizzly day in April, and Private Equity International is in Corby, a land-locked town in the East Midlands region of the UK, to see British luxury yacht manufacturer Fairline unveil its new high-tech production line. Despite the economic gloom, Fairline is bouncing back from the torrid time it had post-crisis – thanks to a well-executed turnaround strategy overseen by a listed private equity manager that trades at a premium to net asset value.  

Apart from the weather, it’s hard to know which bit of this scenario is the most implausible.

Better Capital, which bought Fairline in July 2011, is the latest venture of industry veteran Jon Moulton. It manages two London-listed funds, which invest in distressed or underperforming businesses in the UK and Ireland – just like Fairline.

“If you look at the sector, there’s a lot of consolidation going on,” says Nick Sanders, managing partner and head of portfolio at Better, explaining the rationale behind the deal. “So we felt that if you could get a good turnaround going, when the time came, you’d probably find there were a number of people interested in buying it.” 

Since getting its hands on the tiller, Better has overseen a number of new boat launches and extended the company’s sales efforts into new markets like China and Egypt. The gleaming new manufacturing facility on display today – a mightily impressive sight, at least to this untrained eye – is the icing on the cake.  So it looks like the investment is nicely on track. “We’re happy with it,” agrees Sanders. “It’s a really good example of what Better does.”

What Better does is something that has been attracting a lot of attention in the last year or so, not least from its peers in the listed private equity sector. After all, since its launch in 2009, Better has consistently traded at a premium to NAV – at a time when many listed groups have been struggling with discounts in excess of 20 or even 30 percent. So what’s Better got that they haven’t? 

The cynics argue that it’s largely a reflection of how thin the trading is in Better shares. But according to the ever-forthright Moulton, Better is outperforming the market for three key reasons. “We are distributing, rather than reinvesting proceeds as a permanent capital vehicle would do. We have no fees based on net assets. And we are a market leader in a very popular area [which is turnaround investing].” 

It’s certainly true that Better’s strategy is a timely one – and that’s not something other listed groups could easily replicate. But is there more they could be doing on the other two points?

THE ‘D’ WORD

It’s worth noting that the last year has actually been pretty kind to listed private equity, at least by recent standards.
The LPX 50, an index of the 50 biggest listed private equity groups worldwide, is up about 43 percent year-on-year, compared to 24 percent for the S&P500 and 25 percent for the MSCI All-share. So far in 2013, the LPX 50 is up about 20 percent, again outstripping the S&P500 (up 15 percent) and the MSCI (up 11 percent). And discounts to net asset values have continued to come down to more reasonable levels, despite a steady rise in NAVs across the board.

This improvement is partly just a correction after a couple of years of underperformance. And it’s also because investors have been shifting their allocations into ‘riskier’ assets in search of yield, which has boosted equities across the board.

“The share prices of listed private equity vehicles have had a good run in the last six months,” says Peter McKellar, partner and chief investment officer at SL Capital Partners. “For a period of time sentiment was negative, and there were more sellers than buyers. Most people who wanted listed PE on the institutional side had it already, so it only took a small amount of selling activity to cause a substantial erosion in share prices and a widening of discounts.

Now we’ve moved into a more interesting environment, where there appear to be more buyers than sellers. We’ve started to see retail flows into equities more generally and that’s had a trickle-down effect into listed PE.”

There’s another important caveat to remember when talking about discounts: as a guide to the health and performance of individual managers, they leave a lot to be desired. 

 “Discounts are largely a reflection of confidence in equity markets – they widen when there’s a ‘risk-off’ view, and narrow when there’s a ‘risk-on’ view,” says Alex Fortescue, the chief investment partner at Electra Partners. “What intrigues me is that there is less differentiation between listed PE players than you’d expect. If you look at the funds that have consistently outperformed and underperformed, there’s less of a difference than you’d expect in terms of discounts. It’s frustrating, but it is what it is.”

“Focusing just on the discount assumes that every manager is the same and produces the same performance,” points out Ian Armitage, the former chairman of HgCapital and the outgoing chairman of LPEQ, an industry body for listed private equity trusts. “And yet history says this has never been the case; there’s been quite a wide dispersion of returns.”

That’s not to say managers should ignore them, of course. “We spend a lot of time thinking about discounts,” insists Fortescue. “But since they’re by and large a symptom of confidence, we’ve concluded that there’s relatively little we can do to actively influence [them] – other than sticking to the knitting, making good investments and delivering underlying growth in net assets.”
 
TO YIELD OR NOT TO YIELD

Moulton might beg to differ, however. Investors seem to like Better’s explicit distribution strategy; would its peers be trading at lower discounts if they too were doing more to return capital to investors? 

“We really struggle with the idea that private equity – which by definition is a capital growth story that doesn’t generate income or predictable cashflows – can be readily fitted to a dividend strategy,” admits Fortescue.

“The reason people invest in this sector is for capital gain over time,” adds McKellar. “People have become more focused on income, as they have across most asset classes. But the primary driver of returns will always be capital uplift, and the primary focus of the manager should be capital appreciation.”

However, Stuart Howard, chief operating officer for European listed products at HarbourVest Partners, takes a slightly more nuanced position. “Listed PE can’t deliver real income yield long-term, because if you manufacture dividends it eventually eats the vehicle. But what you can do is share out profits and treat your shareholders like LPs – so if you invest in a fund and it does well, you get your money back and can choose whether or not to recycle it. If you have no cash coming back, your only option is to sell your shares and that’s quite unattractive. So I think the returns of capital people are doing are positive – as long as they’re based on a sharing of profits.”

At the end of May, HarbourVest said that it would pay out about $40 million to its investors in the next two years, effectively as a fast-tracked profit share following its two recent acquisitions in the listed space, Absolute Private Equity and Conversus Capital. The deals were relatively recent, but HarbourVest is so confident in their prospects that it’s paying out a sum it doesn’t expect to collect in real terms until 2017 using current cash flow. “This is a unique opportunity for us to put into practice a ‘share of profits’ mechanism, based solely on these two deals – almost as a reward for the leverage risk that we asked our shareholders to take on,” says Howard. “[But] this is not a yield; this is a 50 percent share of expected profits.” Still, it’s clear that HarbourVest believes in using distributions as a way to boost the share price in the short term.

In general terms though, it seems unlikely that this strategy is going to catch on more broadly. For one thing – and not withstanding one-off situations like that of HarbourVest – it’s extremely difficult to do in practice, in terms of managing cash-flow. Secondly, and perhaps more importantly, it doesn’t actually seem to make much difference to the discount, as the chart on p. 46 shows.

“There’s no evidence at all that returning cash by way of dividends narrows discounts,” insists Fortescue. “Clearly returning cash through buybacks does while the buybacks are happening, but not in the long term. By and large, the entities that have decided to pay dividends have had a performance question mark or problem – so it’s a response to an underlying issue rather than anything else.”

And what of Moulton’s other argument – that listed groups shouldn’t be charging fees based on NAVs? His argument is that this creates a conflict, by encouraging people to buff up their valuations. But if anything, the reverse seems to be happening. Analyst Louisa Symington Mills (then of RBS, now at Jefferies) completed a study last year of 17 of the biggest realisations affecting listed PE over the preceding 12 months: she found that, on average, managers had achieved a premium of 69 percent over book value on exit. Admittedly, managers have mostly been selling their better assets, so this is probably not a true reflection of the overall picture. But managers are inclined to err on the side of caution – partly because of accounting strictures, and partly because nobody wants to book a loss when they sell an asset.

LOOKING POSITIVE

There are plenty of reasons for listed private equity managers to be positive about the next few years. 

In general terms, private equity portfolios are typically in good shape, often with reduced leverage levels. Armitage believes the extent and pace of change in the post-crisis world will throw up more opportunities suited to private equity ownership; while Fortescue suggests that there should be less competition as capacity comes out of the market, dragging down prices.

But there’s also a good argument that listed private equity vehicles are particularly well suited to investors’ changing demands.

According to Howard, the idea of committing capital over a five-year period, with no control over when it gets drawn down, is becoming increasingly unattractive. “Investors want the ability to get invested in a fully seeded portfolio that’s diverse and liquid, and then get out when they want. And they want to manage their own capital or cash flows.”

“The compelling premise of listed private equity is that it dramatically reduces barriers to entry – so it’s appealing to investors who couldn’t invest in the traditional private equity model,” says Kate Ashton, a partner at law firm Debevoise & Plimpton. “All the big firms at the moment are looking at ways to diversify their funding base and allow more investors to come in and out. And that’s the big appeal of listed private equity.”

More regulation could help its cause, too, she adds. “The layer of regulation you have to swallow to be a listed PE manager is not as bad as it was 10 years ago. The gap between the two models is lessening, and in the long term that should benefit listed private equity.”

For the direct investment groups like Electra, having a permanent capital vehicle is also a big help, particularly in the current environment. “Permanent capital has a very manifest advantage in terms of not having the distraction of having to go out and fundraise,” says Fortescue. “But more significantly, it influences the way we invest. We typically hold our investments for longer; we don’t have the same sort of race as a 10-year fund, where your investment period might be working against you. That’s a message that really resonates at the moment.”

IMAGE PROBLEM

But there’s a catch. Most groups are still trading at a discount that’s well above their long run average (which is somewhere in the low to mid-teens). And these discounts are still well below the level at which you can currently buy and sell LP stakes on the secondary market. 

On the one hand, this is arguably a great buying opportunity. “There’s still a huge amount of value left on the table for new investors,” insists Howard. “If you buy our portfolio at 75 cents on the dollar, which we value at $1 and then sell at $1.30, in a different market valuation world, based on forward earnings, we’d be trading at a 10 or 20 percent premium. But – maybe because of fear – [investors] can’t or won’t believe the valuations.”

However, it’s also a warning sign, because it shows that the listed model has yet to convince many investors of its worth – despite the model proving far more resilient after the crash than the markets apparently expected. 

Managers complain that some prospective investors still see listed private equity as risky (because of the leverage aspect), and some still see it as volatile (largely because of its post-crash performance, when discounts plunged to 60 percent and some groups even traded below their cash value). 

Even at the recent LPEQ conference, where the investors in the audience were generally supportive of the sector, some of those present said they’d like to have a broader range of vehicles in which to invest; others wanted to see managers picking up the pace on the investment front; others called for managers still trading at big discounts to take more drastic action. “If you’re trading at a 30-40 percent discount, you don’t have a raison d’être,” argued Chris Wyllie, chief investment officer of asset manager Iveagh. 

There are anecdotal suggestions that wealth managers are returning to the sector, having steered clear of it since the battering they took during the crisis. But clearly there are many who are still to be convinced.

And while managers may bemoan investors’ inability to differentiate between their respective business models, this only highlights the fact that they need to do a better job on the education front.

“First, we have to deliver performance,” says McKellar. “Second, we have to go out and promote both the trust and the sector. We can influence discounts to an extent, but this is very much a sectoral thing – it comes back to the issue of general sentiment.”

 The sector as a whole needs to be doing more of this, says Armitage. “I think you’ll see people put more resource into marketing … Tell your story; do it consistently; perform. Eventually the penny will drop.”