It has certainly been difficult to escape the increasing coverage of private equity in the UK press in recent months. From Alliance Boots’ £11.1 billion sale to private equity group Kohlberg Kravis Roberts (KKR) to CVC’s failed bid for Sainsbury’s – even the Chinese Government is getting in on the act, paying £1.5 billion for a ten per cent stake in US private equity firm Blackstone. But along with all these headline-grabbing events, private equity has also seen its fair share of negative press. European trade unionists recently called for an end to favourable tax treatment for the sector in a bid to raise funds to repay those whose pension schemes collapsed after failed venture capitalist buy-outs.

Hamish Mair, head of private equity funds at F&C, says, ‘There has been quite a lot of fairly uninformed negative comment, with a lot focused on the remuneration of those involved in private equity and the fact that they are often seen as asset-strippers. However, private equity firms have to grow the company in most instances in order to be successful.’

Indeed, the British Venture Capital Association (BVCA) claims that over the past five years, jobs in private equity-backed companies have grown faster than in FTSE 100 and FTSE 250 companies. Mair continues, ‘There is a bit of an issue in that the industry has probably been overly reticent and has not defended itself as well as it might. Some of the leading players do earn a lot of money, but they have also taken risks and worked hard. Lots of institutional investors have benefited, which means pension funds and so on.’

Gaining access
As Mair points out, many pension funds invest in the sector, making money from its rapid rise and recent success. But private investors can get in on the act too.

A sector traditionally seen as the preserve of the wealthy and well connected, it actually boasts a vibrant investment trust market, lowering the financial barriers to entry for investors. The official Association of Investment Companies’ (AIC’s) private equity sector includes 14 investment trusts (soon to be 13 after the merger of August Equity and Rutland Trust to become New Star Private Equity Investment Trust – NSPEIT – see below) and two split-capital investment trusts.

Private equity trusts operate in much the same way as more general investment trusts. Investors can pay a lump sum or a monthly amount via a savings scheme to buy shares in the trust, gaining access to a wide range of investments. The fund can provide diversification based on geography, sector, strategy, time or even company stage – for example, early-stage or new firms, management buy-outs or mezzanine financing (a mixture of debt and equity funding, usually used for existing firms).

Investment strategies

There are two main types of private equity trust – those that invest directly in private businesses, and funds of funds investing in other private equity funds. Some trusts are also an amalgamation of the two types. For example, says Mair, ‘The F&C Private Equity Trust is a fund of funds with co-investments: we invest two-thirds of our money in funds and one third is invested in private companies.

‘We have a global mandate but more than 70 per cent is invested in the UK and Europe. Most of this is mid-market, buy-out and mezzanine financing.’

He adds that a well-diversified portfolio mitigates a lot of the risk involved in private equity investment. ‘A fund of funds aims to provide maximum return through good selection, but also diversification,’ Mair explains. ‘We are decreasing the relatively high risk of private equity, but also aim to provide strong returns through our selection of private equity managers.’

Standard Life Investments, on the other hand, runs a fund of funds investment trust. Peter McKellar, chief investment officer, private equity at Standard Life Investments, explains, ‘We are a fund of funds and deal in European buy-out and blue-chip buy-out funds. We tend to look at mid-market and large buy-outs from a200 million to a2 billion, so the medium- to large-cap part of the buy-out market, not mega-cap and not smaller-cap.’

McKellar lists a number of recent regulars in the financial news as participating in this process – Apax, Permira and Candover. ‘All European buy-outs and only very good ones,’ he stresses.

Brian Scouler is a director of Dunedin Capital partners, manager of the Dunedin Enterprise Investment Trust. This fund invests directly into companies, rather than going down the fund of funds route. It has a wide variety of holdings: ‘It is almost exclusively buy-outs throughout the UK that we focus on,’ he says. ‘This can be any type of company, from glass manufacturing to car insurance.’

Scouler adds, ‘We are very active compared to investment managers in other sectors as we get involved in the management of the company. Investing in private equity is all about backing the right manager and looking at how they have performed compared to others.’

Going global

Private equity originated in the US, but has since taken hold in the UK and is spreading to Continental Europe, Eastern Europe and even into Asia and other emerging markets. The UK boasts the most active private equity sector in Europe and figures prepared by the AIC for the Initiative for Private Equity Investment Trusts (IPEIT – an industry trade body) certainly bear this out.

They show that the average sector share price rose by 17.98 per cent over one year to 30 April 2007, and showed a 285.37 per cent increase over ten years. This is compared to a 12.68 per cent and 109.83 per cent rise in the FTSE All-Share Index over the same periods. The MSCI World Index fared even worse in comparison over these two periods, with a 3.70 per cent rise over one year and a 63.32 per cent increase during the ten years to 30 April 2007.

Investment trusts are viewed as a less risky entry point into private equity, but unfortunately, the existence of such good returns means there has to be a certain level of risk involved. You are investing in companies (or in funds that invest in companies) that are either relatively early stage or at a critical point in their development, so the potential for failure is inherent. Mair elaborates, ‘You are generally dealing with smaller companies than those listed on the stock market, plus they usually have more debt – typically, two-thirds debt to one-third equity. They also tend not to have the same strength and depth of management that listed companies do.’

He stresses that ‘All these reasons and more make private equity riskier for individual and/or inexperienced investors. However, you should be paid for those risks, and so you could get a better return than that from investing in funds of quoted company investments.’

Of course, any sector that has seen returns as good as those enjoyed by private equity in recent years is going to be dogged by rumours of an imminent collapse. Mair is fairly sceptical about this. ‘No sector can defy gravity forever, but I don’t think private equity is about to collapse. The fund managers involved in this sector have to deliver absolute returns, so they won’t invest unless they think they are buying at a good price. Therefore, they won’t pay over the odds, so the chances of a collapse are not as high as the average newspaper would have you believe.’

But there is a lot of money being pumped into the upper end of the market – the Alliance Boots/KKR deal mentioned above is a good example – and this is where the risk is, according to Mair. ‘There is a lot of money and competition for deals, and so there is a danger that things will be overpriced where bigger deals and companies are concerned,’ he explains.

McKellar agrees that those interested in private equity investment have to be shrewd when looking for managers to back. ‘There are still good returns to be made going forward, but you need to ensure that what you go into is not overpriced, considering the amount of attention and demand focused on the private equity sector recently.’

Those looking for a fast-paced investment sector with a healthy dose of risk could find what they are looking for in private equity. And with the band of investment trusts dedicated to this particular area currently being boosted by excellent returns and growing outside interest, access has never been so simple for the private investor.

This article is from What Investment Trust, which is available with the July 2007 issue of What Investment.