NEWSLETTER March 2016

The benefits of investing

in private equity
Institutional investors are continuing to look for lower cost investment solutions.
That’s why investments that require high levels of resources and have associated
higher costs are being asked to justify their fees.
As a result, many investors have been questioning the viability of private equity
as part of their diversified investment portfolios. In this article JANA goes
back to basics to outline what private equity is, what role it can play within a
diversified portfolio and then finally, why JANA still supports selective exposure
in client portfolios.

Matthew is a Consultant, Head of Private What is private equity?

Equity Research Team and a member of
the Direct Investments and Infrastructure Private equity is much like owning a stock in a publicly listed company except it involves taking
Research Teams. an ownership interest in an underlying set of private (or unlisted) businesses or assets. Private
equity investing seeks to generate superior returns by pursuing an active role in monitoring and
Since joining JANA, Matthew has advised advising companies, and through operational and corporate governance improvements in order
clients on a number of transactions including to sell the investment at a premium.
a European gas distribution network
and Australian Public Private Partnership Private equity can be classified according to a company’s growth lifecycle (as seen in Figure 1).
investments. Matthew is also part of JANA’s Figure 1: Private equity and the growth lifecycle of a company
Private Equity and Infrastructure Research
Venture Capital LBO/Expansion
Team through which he has undertaken y
detailed due diligence on a number of
managers, as well as contributed to various
LBO/Expansion
Growth/Financing requirements

research pieces.
Expansion Capital
Prior to joining JANA in 2008, Matthew was a
research analyst for MLC’s ThreeSixty Research Venture Capital

Solutions managed funds team. Matthew Start-up Funds

also completed the two-year MLC Graduate
Business Angels
Program with rotations in Accounting and
Finance. Incubator

Matthew holds a Bachelor of Engineering, Family Capital

Master of Information Science and a Master of

Commerce (Finance & Accounting) from the R&D Start-up Take-off Development Maturity & Sale t

University of NSW. Matthew is a Chartered

Financial Analyst charterholder. Source: Credit Agricole Private Equity

Some of the most common private equity investment strategies include:

• V
 enture capital – finance provided by investors to smaller start-up firms, typically invested in
an early stage company with negative cash flows that needs support until its product can be
commercialised. Due to the nature of the investment, the outcome for venture capital tends to
be a more binary outcome (home run or capital loss). This type of investment has considerable
risk, although as demonstrated by Atlassian, Facebook and other companies, the payoff can
be extremely large. Venture capital is more suitable for investors with a mature private equity
program, who can withstand the potential for substantial capital losses and who have the
patience to ride the long journey of venture capital.

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The benefits of investing in private equity

• B
 uyouts – which includes Management • A
 lignment of interests – private equity has the potential to improve the alignment of
Buyouts, Leveraged Buyouts (LBO) and interests between investors and management through the use of incentive structures that
Expansion Capital, occurs during all phases may be unfeasible to implement for a listed equity manager. For example, management and
of growth for established companies the General Partner (GP) are often provided with the ability to invest their own money (“skin
where use of leverage, enhanced corporate in the game”) alongside investors; and earn out provisions may be applied.
governance and operational efficiency are
• H
 igh fee structure – private equity fee structures are significantly higher relative to other
used to improve the performance of the
traditional asset classes, with management fees on committed capital typically 1.5% to 2.0%
company.
pa plus a performance fee of around 20%. If investors are investing through fund of funds
• Distressed/special
 situation – an structures, there will be an additional layer of fees. Although the private equity approach
investment strategy that involves purchasing is more active and hands-on compared to listed equities, it is arguable whether the high
the discounted bonds of a financially fee structure can be justified. However, it is difficult to pressure managers to reduce their
distressed firm. Distressed debt investors fee structure, especially those top-tier managers who tend to be oversubscribed by investors
frequently convert their holdings into equity when fund raising. Private equity fee structures are a topical subject that warrants a separate
and become actively involved with the piece and we’ll cover this subject in the future. However due to the high fees and the large
management of the distressed firm. discrepancy of returns between top and bottom ranking managers, choosing the very best
opportunities is paramount.
What are the main • Barriers
 to entry – private equity funds generally require a relatively large minimum
characteristics of private investment commitment amount (>$5m-10m) and for investors to establish a diversified
equity? private equity program requires significantly larger commitment amounts. Hence, for smaller
investors, private equity investments are generally harder to access, although there are means
Private equity has a number of unique to access private equity in a diversified manner via fund of funds structures or secondary
characteristics that potential investors should private equity markets; albeit at a higher fee level.
consider in the context of their own investment
circumstances. The main characteristics are:
What is the role of private equity within a diversified portfolio?
• I lliquidity – private equity is typically long
While there are a number of roles that private equity can play within an investor’s diversified
term and illiquid due to the investment
portfolio, depending on their preferences and situation, we believe its primary role is to access
characteristics of the portfolio companies
high returning investments that are not directly correlated to equity market returns.
and the private equity fund structure
(generally 10 years plus extensions). For Figure 2: Private Equity IRR Quartiles by Vintage Year. Performance of Private Equity
investors with a longer time horizon and since 1991.
patient capital, this should not necessarily 35%
be a cause for concern. Conversely, for
30%
investors with a shorter time horizon (less
than 10 years) and a need for liquidity, 25%

private equity investment should not be 20%

considered. 15%

• J-curve
 effect – investors in private 10%
IRR (%)

equity will typically experience a “J-curve” 5%

effect, where they will experience negative 0%
cumulative cashflows during the initial
-5%
phase, as committed capital is drawn down
for new investments and fees are paid on the -10%

committed capital. As investments mature -15%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
and realisations are sought, the cumulative
Vintage Year
cashflows will start to turn positive as
Upper Quartile IRR Median IRR Bottom Quartile IRR MSCI World
investors receive distributions from the sale
or exit of its private equity investment. It can Source: Hamilton Lane Fund Investment Database (November 2015) MSCI World, net reinvested Dividends. Benchmark
therefore take several years to have a clear calculated as PME (Public Market Equivalent) using all private equity pooled cash flows.
assessment of performance. • Potential
 to generate high returns (after fees) – private equity investments have the
potential to generate outsized returns – a key rationale for investing in the asset class. If
• V
 olatility – private equity investments private equity investments cannot generate high net returns relative to traditional asset classes
generally tend to have lower price volatility to compensate for its illiquidity and heightened risk profile, there is little point in considering
compared to the listed equities market due private equity. Figure 2 displays the performances of private equity funds by vintage year
to the frequency of valuation, which tends (otherwise known as the first year in which investment capital is deployed) and depicts a
to range from quarterly to annually. The couple of interesting observations. Firstly, the dispersion between upper quartile, median and
lower price volatility does not always reflect lower quartile private equity performances are quite significant throughout the vintage years
going back to 1991. Interestingly, private equity tends to exhibit greater manager performance
lower company risk. persistency than traditional asset classes. This means that upper quartile managers will tend to
• A
 ctive capital – managers often take an generate upper quartile performances for their successive funds. The second observation we
can draw from Figure 2 is that upper quartile private equity performances have significantly
active role in the portfolio company via outperformed the MSCI World Index since 1991. These observations demonstrate that private
board representation and other executive equity has the potential to generate high returns relative to the listed markets, especially if
positions. In contrast, investors in public investors are selective and invest with the upper quartile managers.
companies rarely have board seats or a
 JANA, we have been emphasising the importance of manager selection, especially within
At
controlling interest. the private equity asset class. Accessing upper quartile managers is essential to having a

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The benefits of investing in private equity

successful private equity program. Investors Why are we still supportive of manager quality. History shows that gaining
need to spend time and effort in identifying access to upper quartile managers is essential
and establishing relationships with these private equity? to having a successful private equity program.
upper quartile managers. Despite the heightened risk profile, unique As much as the potential high returns
 iversification – private equity can
• D nature of private equity relative to traditional generated from private equity investments are
provide diversification benefits when asset classes, and relatively high fee structure, important, JANA continues to focus on finding
used as part of an investment strategy we continue to be supportive of private equity solutions to reduce the overall fee levels for
as the asset class provides exposure to investments on a selective basis, where the our investors, whilst maintaining the quality
an expanded opportunity set, including investment can provide an opportunity to of the private equity portfolio. Strategies to
companies too small or unsuitable for generate a high post fee and tax return. The reduce overall fee levels will depend on each
listed markets; as well as early stage and exposure should also improve the portfolio’s investor’s circumstances and may involve
growth capital businesses. There are also overall diversification. working closely with the managers to derive
sectors and regions where private equity JANA takes an opportunistic/selective a suitable solution. These strategies include
is able to provide better access relative to approach to investing in private equity. In transitioning from a fund of funds model to a
listed equity markets, especially in emerging practice this means we allocate to private separate mandate account or a direct private
markets. Industries such as Consumer, equity when we can identify an opportunity equity program with a more favourable fee
Healthcare and Information Technology are that is more attractive relative to traditional structure. Another strategy could include
poorly represented in the listed markets for asset classes, and with a high quality manager. introducing private equity co-investment
countries like China, Brazil and also MSCI Due to the long term illiquid commitment funds in the portfolio to help reduce the
Frontier Markets. These industries in the to the manager, we do not compromise on overall fee levels for investors.
emerging markets are better represented
in the private markets, where private equity
managers can more easily access these
industries compared to listed markets.

Conclusion
Private equity by virtue of its unique characteristics is not a mainstream asset class. It’s therefore important for investors to have a clear and
unequivocal understanding of their investment objectives and risk tolerance before considering this asset class.
However, for longer term investors who can tolerate the unique characteristics of private equity, investment in this asset class can be very
rewarding. Especially in the current market environment where long-term forecast returns from traditional asset classes are looking subdued,
investing in private equity can provide an opportunity to generate a higher absolute return, while improving a portfolio’s overall diversification.

Issued by JANA Investment Advisers Pty Ltd (ABN 97 006 717 568) (AFSL 230693).
Information current as at April 2016. This document may not be copied or redistributed without the prior consent of JANA Investment Advisers Pty Ltd. This
document is intended for use only by persons who are ‘wholesale clients’ within the meaning of the Corporations Act. It is intended to provide general information
only and has been prepared without taking into account any particular person’s objectives, financial situation or needs. Investors should, before acting on this
information, consider the appropriateness of this information having regard to their personal objectives, financial situation and needs. We recommend investors
obtain financial advice specific to their situation before making any financial investment or insurance decision. While due care has been taken in the preparation of
this document, no warranty is given as to the accuracy of the information. Except where under statute liability cannot be excluded, no liability (whether arising in
negligence or otherwise) is accepted by JANA Investment Advisers Pty Ltd for any error or omission or for any loss caused to any person acting on the information
contained in this document. A121581-0316

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