Financial innovation got a very bad name following the 2008 crash, when monstrosities such as "CDO cubed" were seen as adding massive toxicity to the huge volume of asset backed securitizations being cranked out by the big US banks. However, it is in the nature of markets to innovate and to reward innovation. One little noticed instance of this is provided by exchange listed private equity (PE) funds. As the trade body for these funds, the LPEQ, notes, what these funds provide to investors is literally private equity-like returns for the price of a share.
The point, as Ross Butler, External Affairs Director at LPEQ told me in a recent interview for IPE Magazine is hugely important and is as yet only poorly recognised across the universe of investors. This is despite the fact that some funds have been listed at least since the early 1980s. In part this is because listed PE still only amounts to around 5% of the whole PE industry.
"When people think about PE, they think of limited partner (LP) funds which invest directly in PE opportunities. However, the minimum ticket on these funds can be £10 million or more and you are tying the money up for ten years," Butler says.
As such, these opportunities are not for the smaller pension funds or for family offices, by definition, and they are so far outside the retail space that investors do not even begin to consider PE as an option.
Yet to access listed PE funds, all a retail investor has to do is to buy as many or as few of their shares as their portfolio strategy dictates. This is market innovation at its finest. It has taken an asset class that is completely out of reach of ordinary "mom and pop" investors, or even of multi millionaires (since even someone with a net worth of, say £10 million wouldn't want to put half of that in a single relatively high risk asset class, which is what they might need to do to become a partner in a traditional limited partner PE fund). What market innovation cannot do, however, is to completely transform the nature of the underlying asset class - even if it goes some way in this direction. Exchange listed PE funds continue to retain some of the traits of the underlying asset class, the most noxious of which, from an investor's point of view, is PE's inherent lack of liquidity. In traditional PE terms, when you invest in a building, with a view to enjoying rental income and capital growth, you are not investing in order to liquidate your investment next week. This is a five to seven year investment, minimum, and could well be a 25 year investment. This is why pension funds rather like PE. The long term nature of the asset class suits the long term nature of their liabilities, which are to provide retirement benefits to members at the end of a working life that may have decades still to run.
There are three main categories of listed PE fund in the sector. One is a direct listed PE company, which invests directly into a number of enterprises. Another is a fund of funds listed PE company which, as the name suggests, invests in a range of direct listed PE firms, thus spreading its risk across a much larger universe of client companies. The third type of listed PE fund is a listed management company, or LPEC. The latter get the majority of their income from fees charged for the management of assets. They stay in business and prosper if they demonstrate that they can channel investor funds to either of the two previous types of listed PE (direct or fund of funds) successfully, and their ability to do this generates the fee.
One final point about listed PE concerns the valuation of these funds. Because listed PE is about buying and holding for five to seven years, there is only an occasional exit to provide guidance on the overall value of the fund's portfolio. However, the listed PE houses get around this by valuing their funds based on what exits from similar holdings have generated recently. This creates a realistic estimate, but the market remains suspicious of listed PE stated valuations and applies a fairly steep discount to that valuation. This is quite a long winded way of saying that listed PE is generally undervalued, and that for several reasons, listed PE is about as heavily discounted today as it has ever been, with discounts of 40% or more being applied to some funds. The general feeling in the industry is that this discount is in the process of slimming down to around the 15-20% level. This in turn means that listed PE is probably more keenly priced today than it has been for several years. All these factors suggest that 2012 could end up being a very good year for listed PE and could generate some very decent returns for investors at a time when the return on cash is actually negative after inflation.
Further reading on private equity:
- Understanding and Accessing Private Equity for Small and Medium Enterprises, by Arne-G. Hostrup
- Private Equity Fund Monitoring and Risk Management, by Rainer Ender
- Private Investments in Public Equity, by William K. Sjostrom, Jr
Tags: "mom and pop" investors , CDO cubed , CDO squared , CDOs , limited partner funds , listed PE , Listed Private Equity funds , LPEQ , management of assets , PE industry , private equity , retail investor , underlying asset class