Performance – October 2008

As recent surveys make clear, their private equity portfolios have given limited partners much to celebrate in recent years as returns from large buyouts in particular have skyrocketed and distributions come flooding back into coffers. What is more, it could be argued that those GPs which loaded cheap debt onto companies and then recapped with even cheaper debt (sometimes just months later) were the biggest winners in this environment. For those within and outside the private equity market who have depicted financial engineering and the enthusiastic use of leverage as somehow a tainted strategy, this was difficult to reconcile.

Looking back on that period of plenty, one limited partner source adopts the hushed tones of the confessional as he confides: “I like a long-term sustainable investment culture within GPs where operational skills drive the top and bottom line. But I’ll tell you this: if you raised a lot of money for what I’ll call an ‘aggressive recap’ strategy between 2003 and 2005 – buy high, leverage like hell, recap and pull out the cash – that would have delivered a very good realised performance for a period of time. That would have been the perfect strategy.”

One counter to this, as the source in question readily acknowledges, is that such a strategy bombs when the benign conditions that enabled it to flourish suddenly end – as with the credit crunch in the middle of last year. Peter Laib, managing director of Zurich-bas ed funds of funds manager Adveq, casts his mind back to the dotcom bubble and crash for something approaching a parallel: “If you were making pre-IPO investments in 98/99, that was perfect – you got IRRs that just couldn’t be beaten. But if you’d continued that strategy into 2000, you’d have suffered. There were hardly any brand-name US VCs that didn’t get hit in at least one fund. But the 95/98 funds were great vintages.”

In other words, it’s all in the timing – and, therefore, an overreliance on managers pursuing aggressive strategies potentially makes investors hostages to fortune.

And that, of course, is not what private equity investing should all be about. Adds Laib: “If the role of private equity is to substitute public equity and take similar risks, then you could go for GPs that take aggressive financial and credit market risk. But if you want private equity to be a balance to your public exposure, you may want to consider managers following equity-focused strategies. What’s the role of private equity within the portfolio? That’s the thing to consider.”

And that’s why some organisations undertake extensive research in an attempt to differentiate those managers delivering consistent and steady if unspectacular returns from those with a more flamboyant approach that may yield more homeruns as well as more write-downs or write-offs.