Better than good

That life in private equity is getting harder won't come as a surprise to those who live it. Financial engineering as a strategy sufficient to create extra value has been pronounced dead some time ago, and as the market matures, private equity houses have realised that real success depends to a large degree on whether they can find ways of adding value to their portfolio companies that are more effective (and enduring) than the next firm's.

In a similar vein, investors in the asset class have known for some time that for a private equity allocation to produce the desired returns, it helps to have access to the top-performing houses. As a result, one of the dominant themes for limited partners has long been to work out ways to identify those top performers. Although one will be forgiven for making the point that in private equity picking winners is as much art as science, the principle that past performance is a valuable indicator of future returns is being taken as gospel by LPs anywhere, particularly in the current climate.

McKinsey found that the pooled IRR of transactions between 1995 and 2001 had shrunk to 40 per cent

Just how revealing a look at the performance track record of private equity groups can be was recently demonstrated by Conor Kehoe, leader of McKinsey's European Private Equity Practice, at the EVCA Annual Symposium in Athens. Analysing the performance of European LBO houses over the past 15 years, McKinsey found that it was only the top quartile firms that had emphatically outperformed the public markets during the past 15 years, and had done so on a consistent basis.

According to Kehoe, whose detailed findings were based on an analysis of just under 20 top quartile European LBO funds, a firm that achieved top-quartile performance with one fund stood a 50 per cent chance of repeating this with their next fund. In other words, top quartile players in Europe had a 2:1 chance to maintain their performance relative to their peers from one fund to the next. More instructive still, a fund ranking among the top ten per cent of best-performing vehicles in the market were found to have a 3:1 chance, relative to peers, of being followed by an equally successful vehicle. Half of the good will be good again it would seem, but the best will be that much more likely to be the same again.

McKinsey then asked whether there were any shared characteristics that enabled the leading firms to outperform so persistently. Rejecting fund size and gearing levels as non-correlated factors, the consultants found that the impact on IRR of country focus and industry specialisation did follow a certain pattern, albeit a fairly insignificant one. What impressed the researchers more was the finding that consistent top performers were likely to have one of two different investment strategies.

Type one funds, says McKinsey, generated superior returns by helping their most successful portfolio companies outperform their peer group. Their top two portfolio companies typically accounted for around 50 per cent of total value they generated, where the GP had executed a significant change of purpose or strategy after acquiring the companies. (A change of purpose could have resulted from a privatisation or carve-out from a larger parent, while a change of strategy would have followed a fundamental strategic repositioning or industry roll-up for instance.)

Type two funds benefited from targeting industry sub-sectors that subsequently went on to outperform the market. Here, general partners invested in companies in sectors that the market had failed to value properly. Once the error was corrected, GPs benefited from the uplift without necessarily having improved a company's performance relative to its peer group. In fact, says Kehoe, the majority of companies managed by type two funds had actually deteriorated relative to their peers during the holding period of the investment.

McKinsey notes that the second strategy, still common in Europe, was not evident in a study of top quartile firms in the US. This highlights the fundamental difference in maturity between the two markets, and suggesting that Europe remains a less efficient market place where private equity managers can operate with greater leeway. However, there is concern that the supply of mis-priced assets is drying up in Europe too. One indication that this is indeed happening is that the average duration of realised deals is rising, as short-term, arbitrage-driven bets are becoming less lucrative and value-generating strategies take longer to be executed. Says Kehoe: ?There will always be sector moves within industries, but it is getting more difficult to continue to pick the right ones.?

Investors will be reluctant to put their money behind firms that may be good but do the same thing

As a result, firms are having to work harder to generate returns. As the European market becomes more competitive, the more traditional, financially driven private equity mechanisms no longer suffice to give individual players the competitive advantage they look for. And returns are already under pressure: analysing 352 realised deals of top quartile funds, McKinsey found that the pooled IRR of transactions between 1995 and 2001 had shrunk to 40 per cent from the 65 per cent for the period between 1984 to 1994.

But Kehoe remains optimistic about Europe. He expects the top houses to continue to find plenty of type 1 opportunities, enabling them to get deep inside a portfolio company and execute a fundamental change. Privatisation is one of the key sources of relevant deal flow he mentions, and he also points to the ongoing trend among vertically integrated service companies such as utilities and airlines to spin off internal service providers that used to be run as cost centres but have the potential to become independent companies in their own right.

If it is indeed by way of effectively executing fundamental change strategies that GPs generate the best returns, the LPs will become more dependent on their ability to put capital into the best-performing funds. For if it is down to a GP's ability to generate value by effecting change inside portfolio companies, the amount of value added during the holding period of an investment that is due to market movements is likely to be minimal. In other words, not only do top performers generate the highest returns, they also offer the lowest correlation with the public market. As Kehoe puts it: ?A private equity investment only really becomes an alternative asset if you're dealing with the people in the top quartile, because they are the ones doings things that are up above and beyond the market. On average, correlation between the public and the private market is quite high, but the argument is that the average isn't interesting.?

For general partners, this creates a greater need to ensure that they are able to articulate a strategy, and – crucially – that they have the resources to execute this well. This has significant implications on staffing, organisation and compensation structures, encouraging further institutionalisation among GPs.

It also puts pressure on private equity firms to pick strategies that differentiate them from their peers. LPs must be able to clearly recognise differences between individual GPs if they are to continue to allocate capital to a large number of competing houses. ?It must be a bit soul destroying if you are an investor to watch your money compete with itself.? says Kehoe. ?Investors will be reluctant to put their money behind firms that may be good but do the same thing [as each other] and are likely to end up bidding against each other.?