From the January 2008 issue of Investment Advisor • Subscribe!

The Private Equity Solution

The PE pathway to diversification

The Asian currency crisis ushered in a new era in the practice of portfolio management. This event signaled a warning to many investors who were previously unaware that the global economy had matured to the point where activities across the globe could impact their domestic holdings. Joost Driessen and Luc Laeven concluded in their study of a 17-year span ending in 2002 that portfolio exposure to developed international countries offered very large diversification benefits at the beginning of this period, but that these benefits decreased by the end of the period.

The challenge for advisors in today's low-return environment is to identify asset classes that are uncorrelated to the existing elements within a portfolio, and that can therefore provide the excess return desirable when undertaking the unique risks associated with new asset classes.

Hedge funds and emerging markets are two asset classes that were added to the tool chests of many advisors over the last 10 years. These vehicles became even more mainstream with the advent of a few mutual funds that offered the characteristics of these asset classes to the investing public at large. In the past few years, private equity funds have garnered the spotlight with noteworthy acquisitions of public companies such as Chrysler Corporation, Hertz, and Toys "R" Us.

As with the above examples, private equity can mean the privatizing of a public company to add value, which couldn't be done as efficiently if the company was left in its former mode. The ownership team that bought Chrysler was able to poach key talented managers from other automakers because they could offer compensation packages that publicly traded companies couldn't due to shareholder activism. Private equity can also involve the purchase of a division of a larger company to provide the resources and attention needed to create value. It may also involve purchasing a company that is already private, and then offering access to additional capital or talented management with the goal of significant value creation.

The Outperformance Advantage

Private equity advocates point to many reasons why private equity should outperform its public counterparts.

  • In a competitive industry, private company management has the advantage of keeping strategic initiatives close to their vests, unlike public companies that are required to disclose investment decisions to their shareholders and the public.
  • Analysts and investors have placed great importance on quarterly earnings reports and this has led many managers of public companies to focus on short-term growth to meet those short-term expectations. Managers of private companies can focus on long-term growth to unlock the greatest amount of value.
  • Costly governmental regulations imposed on publicly traded companies (such as Sarbanes-Oxley) can be quite expensive and limit the companies' ability to maximize long-term profits.
  • Thomson Venture Economics found that the annualized return for private equity funds over a 10- and 20-year period was 100 and 210 basis points higher, respectively, than the S&P 500. Leibowitz and Bova's 2004 study concluded that private equity funds had a 0.70 correlation to U.S. equity, negative correlations to government and corporate bonds, and low correlations to other asset classes. A manager that subscribes to Modern Portfolio Theory could use private equity as a tool to lower volatility and increase portfolio return.

Past issues of Investment Advisor have included articles on the trend of advisors investing in private equity. Articles by Michael Fischer in the September 2007 issue titled "Getting In," and in October 2007, "Behind the Numbers," detailed the due diligence process for private equity funds.

If you have decided that private equity is the right asset class in which to invest client funds, do you have choices other than investment into private equity funds? Private equity funds have the disadvantage of large fees that in a majority of cases eliminate any alpha produced by the fund manager.

Direct Investment

There are three main challenges to be addressed before a direct investment in private equity should be made: illiquidity; adverse selection; and talented management identification.

Illiquidity. Illiquidity is an issue with which an investor must be comfortable. There might be an established business plan calling for a five-year ownership term, but the business cycle (or any number of other factors) could render original estimates inaccurate. For investors, there is no surrender period (as offered by many private equity funds) and no thinly traded secondary market for private equity fund shares (as has been initiated by investment bankers such as OffRoad Capital). To maximize the value of the investment, it's conceivable that the holding period could shorten or elongate by a large factor. However, with the advent of more private equity funds and institutional money managers now making direct investments, there are now more options available than there were 15 years ago to exit these investments. Traditional exit strategies were limited to a merger or sale to a private equity fund or company in the industry, an initial public offering, or a recapitalization.

Adverse Selection. Once expectations of the variability of the holding period have been addressed, the problem of adverse selection must be overcome. Well-managed profitable businesses are rarely available for sale at an attractive valuation. The first option is to sift through the hundreds of businesses for sale that are available to the public in an attempt to identify the few that are valued attractively and that have the best potential to offer an adequate return. The other option is to solicit companies that are not for sale by offering an incentive--usually in the form of an attractive price.

Finding Talented Management. The integral component for creating value in a direct private equity investment is identifying and hiring the correct managers of the company. The correct manager or management team might already work for the company; they might work for a competitor, or they might be in a completely unrelated industry, but the crucial factor is that they are willing to buy into the vision for value creation that you've identified.

Only after these three factors have been satisfactorily addressed should a private equity investment take place.

One such direct private equity investment I made was the purchase of assets from DDX, a distressed Denver company that owned a product called Heat Watch. The Heat Watch system involved a radio transmitter device that was attached to the tail of a cow to detect when the cow was in estrus and ready to be bred for artificial insemination or embryo transfer purposes. The data was transmitted to the farmer's computer so that the farmer could make more accurate breeding decisions that would increase conception rates and, ultimately, the profitability of the farm.

The company fit the model of the prototypical distressed company badly in need of a restructuring. It had accumulated close to a million dollars in debt and the cost of servicing that line of credit was unsustainable, given the company's current revenue and profit margins. The analysis of the current business and recapitalized income statements and balance sheets were straightforward.

The analysis of the business determined that these important criteria were met:

  1. The industry must be understandable to investor(s);
  2. The barriers to entry must be high;
  3. The business must be solid on its own merit;
  4. There must be an opportunity for excess value creation;
  5. The worst case scenario must be better than a market rate of return.

(1) I had a very good working knowledge of the business as I had been raised in the cattle industry. (2) The barriers to entry were huge because the main product line had worldwide patent protection. (3) By simply cutting certain costs and removing the debt service through the acquisition, the company was profitable, and it was a solid business on its own merit. (4) I identified the potential for dramatically increasing sales by improving the main product and developing a product that was in the company's intellectual property portfolio. Either item could potentially greatly increase the company's earnings. (5) The worst case scenario was that lacking future growth and new product sales, and with additional cost cutting, the company still yielded a profitable investment. The company would make a 5%-10% internal rate of return. If we did our job right and we were good managers and the macro-economic situation met our forecast, we would be hitting a 25%-30% internal rate of return. The five criteria were met; the investment was made, and it has been a very profitable part of my private equity portfolio.

Pooled Asset Funds. The process of identifying and managing a portfolio of private equity companies is time-consuming and requires a specialized skill set, so it is surprising that the use of pooled asset funds has not become more popular. This vehicle allows an advisor or group of advisors to pool client assets and set the compensation structure at a palatable 1%-2% of AUM, dropping the 15%-20% performance fee. A moderately-sized fund could support a quality manager and support staff.

Private equity can provide benefits for your clients and it can add a new dimension to your practice. Before you direct clients into a private equity fund, a pooled asset fund with other advisors or direct investment should be considered.


Andrew Lucas, CFA, CFP, is a principal of Lucas Capital Advisors, a wealth management firm located in Manalapan, New Jersey. A Princeton graduate in economics and mayor of his hometown of Manalapan, Lucas specializes in private equity investments. He can be reached at andrew@lucascapital.net.

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