WASHINGTON - Opportunities abound in private markets, but investors need to do a little more homework to reap the rewards, according to speakers at Pensions & Investments' Investment Management Conference.
And rewards there are.
Carol Proffer, managing director of The Crossroads Group, Dallas, said private investments have logged the highest returns of any asset class during the past 48 years, citing data from Morgan Stanley & Co. The asset class produced annualizedreturns of 15.9% during the period; its only competition was from small-capitalization stocks, which returned 13.6%.
In addition, private equity investment performance for the one- and three-year periods ended Sept. 30 have outdone the Standard & Poor's 500 Stock Index and the Nasdaq Industrials Composite. For the one-year period, private equity was up 32% while the S&P was up 20.3% and the Nasdaq, 17.6%. The annualized three-year return for each class was 24.3%, 17.4% and 17.2% respectively.
These favorable returns have made private equity a popular investment. Commitments to private equity have increased each year since 1993 when it was at $7.7 billion; in 1996, commitments were at $32.1 billion.
Can private equity pace continue?
While their history is impressive, the larger question, Ms. Proffer said, is whether private equity investments can keep going at this pace. The competitive environment has pushed valuations up, both in venture capital and leveraged buy-outs; and the cycle has become shorter than in the 1980s, when it took investors between seven and 12 years to cash out.
Even so, market opportunities do exist. For venture capital, there is an increased focus on investing in more mature start-ups, as opposed to the early stage investments of the 1980s.
"A key difference is that the majority of investments are being made by experienced venture capitalists, who are backed, in large part, by large institutions, who require more intense research," Ms. Proffer said.
At the same time, strategic corporate acquirers, looking to create economies of scale and build critical mass through synergistic combinations, are willing to pay higher prices to acquire businesses than financial investors.
The level of equity required in buy-outs also is higher than deals done in the 1980s, when highly leveraged transactions were the norm.
4 tips on successful investing
Ms. Proffer offered four ways investors could invest successfully in the private markets: hire exceptional managers; make sure the manager's process makes sense and continues on that pace; learn pricing disciplines; and gain exposure to key segments of the private equity market.
"A disciplined, diversified private equity investment approach through exceptional managers can produce attractive returns in any environment," she said.
But what if the investment goes bad? What kind of recourse do investors have? H. Stephen Grace Jr., president of H.S. Grace & Co. Inc., New York, said the key is to have a structure already in place that allows the limited partners to respond to bad situations. Limited partners are entitled to a broad range of rights in many states, but the rights need to be set out in the partnership agreement.
"People that succeed in this high-risk investment understand the bare-bones rule: you have to have control of the end game," Mr. Grace said.
Pension funds have far greater powers in private equity investments than they usually realize, said Bernard B. Falk, vice president and general counsel at Loeb Partners Realty, New York.
Mr. Grace said a critical element in the organization of a private investment is that the limited partners need to have a strategic oversight structure. Someone needs to watch what's happening with the investment to protect the limited partners' interests.
In addition, Mr. Grace suggests the limited partners set aside a reserve fund, in case they need to hire a specialist to help guide the partners out of a sticky situation. The reserve fund is particularly important to public funds involved in a private investment because overall budget constraints might not allow for last-minute funding if a crisis occurs.
How international deals differ
One concern raised throughout the conference was whether there is too much cash chasing too few deals in the U.S. private equity market. While speakers mostly agreed that this is hard to determine, it certainly isn't true for international private equity, said Charles King, director of international equity research for Evaluation Associates Inc., Norwalk, Conn.
The risk factors involved in international private equity are much different from those in the United States. The largest risk factor is an investor's exit strategy, he said. Certain foreign markets aren't as developed, and so a clear-cut exit strategy is essential.
Another risk is the small number of investment managers specializing in international private equity investments. While the number has grown substantially in the United States, there is still a limited talent pool for international, he said.
"People with U.S. experience are beginning to use (their experience) overseas," Mr. King said. "Sometimes it works, but not all the time."
But despite these risks, Mr. King predicts international private equity investments will increase as a separate asset allocation by plan sponsors.
But investors need to know the basic facts about certain countries, said Terry A. Newendorp, president of Taylor-DeJongh Inc., Washington, an international capital projects development and finance firm. In many emerging markets, exit options might be limited, and remedies for failed investments are virtually nil.
In some cases, "structures may be in place, but there are no participant sanctions if someone doesn't own up to their end of the bargain," Mr. Newendorp said.
Countries such as Brazil, China, India and Turkey have dismal repayment rates, Mr. Newendorp said. The process of total free market reform in countries like Argentina, Chile and the Czech Republic actually has created greater lender/investor risk and lower reward. In addition, many investments in these countries are extremely illiquid and take as long as seven years until project closing.
So where are the opportunities? Mr. Newendorp suggests investments in export-generating projects including petroleum, petrochemicals and mining, or projects relatively free from government changes in laws, such as food processing and plastics.
Another opportunity for institutional investors is in convertible securities, a hugely neglected asset class, according to Tracy V. Maitland, president of Advent Capital Management, New York.
Convertibles - hybrid securities with bond-like returns and the upside potential of equity investments - are neglected because plan sponsors don't know whether to classify them as fixed income, private equity or conservative equity.
"If the stock goes down, (and the investors do not opt to convert their securities into equity), at least you get your fixed return and money back in seven years," Mr. Maitland said.
And while convertibles offer attractive returns with lower-than-market risk, the market for these securities remains a niche, he said.
Between January 1988 and December 1996, the Merrill Lynch Convertible Index produced a total annual return of 13%, with a Sharpe ratio of 1.04% compared with 16.7% for the S&P 500 in the same period, but with a 0.90% Sharpe ratio. The Sharpe ratio is a measure of risk-adjusted returns; a higher ratio implies higher returns with a comparable level of risk.
Given that kind of risk-return profile, it is not surprising the market for convertibles has doubled since 1989 to $190 billion , with a number of investment-grade companies issuing the securities, he said. At the same time, the average maturity of convertibles has dropped to nine years from 21 years in 1986.
Hedge funds grow quickly
Another asset class that is growing rapidly is hedge funds. Hedge funds are the fastest growing asset class among institutional investors, said Mark J. Kenyon, executive vice president at Blackstone Alternative Asset Management in New York.
While traditional investment managers tend to underperform the broad market benchmarks, hedge funds typically do better than the benchmarks in good markets, and don't fall as sharply as the benchmarks in bear markets, explained Alfonse Fletcher Jr., head of Fletcher Asset Management, New York, the investment adviser for a domestic and an offshore hedge fund.
At the same time they provide institutional investors with superior returns to traditional investments, hedge funds also offer diversification and a hedge against traditional investments, he said.
While many institutional investors wonder if they should consider hedge fund investments as part of their stock or bond portfolios, these investments deserve a classification of their own, Mr. Kenyon said.
But while the returns of hedge funds might tantalize institutional investors, Mr. Fletcher cautioned against rushing in without kicking the tires. With hedge fund managers charging 4% in fees plus an additional 20% to 25% in profits, the risk of derivative-based strategies backfiring and the number of new funds popping up, Mr. Fletcher advised investors to do their homework.
"Look for managers with a proven track record" and dig into performance records, he said.