Rewards can be high for private equity investors

Venture capital delivers impressive returns for the risk hungry investor, says Iain Morse

Is it time to invest in private equity? The sector has generated some stonking returns by investing into privately owned, unlisted companies. These can be sold on to trade buyers or other private equity investors, or floated on a stock market to realise investor value. According to the British Venture Capital Association (BVCA), returns for its member funds ran at 14.2 per cent per annum, measured over 10 years to 2004: the FTSE All-Share returned just 6.1 per cent per annum.

Is it time to invest in private equity? The sector has generated some stonking returns by investing into privately owned, unlisted companies. These can be sold on to trade buyers or other private equity investors, or floated on a stock market to realise investor value. According to the British Venture Capital Association (BVCA), returns for its member funds ran at 14.2 per cent per annum, measured over 10 years to 2004: the FTSE All-Share returned just 6.1 per cent per annum.

The private equity universe falls into strata defined by the types of deal and value. The large management buyouts (LMBOs) have a value of £100m or more. Examples of companies that have been through this include Permira and Homebase. Large MBO deals worth billions are increasingly commonplace. Next come mid MBOs ,with a deal value in the £10m-£100m range, the fastest-growing sector.

Below this sits development, where F&C Equity Partners, for example, operates. "Our investments include companies such as Fat Face, the rapidly expanding chain of clothing retailers favoured by snowboarders and skateboarders," says F&CEP's chairman, David Thorp. "As its name implies, development is all about providing capital help for very small businesses to grow more rapidly than would be possible from their retained profits." Early stage is the riskiest stage, but needs the least capital to implement an idea or develop a product to patent. Not surprisingly, many projects fail.

For private retail investors, access to this private equity universe is limited. Most of the capital comes from institutional investors such as pension funds, charity foundations or wealthy private investors. At the coalface, private equity runs via legal partnerships.

The managing or unlimited partners put up their own money, making and managing investments, while accepting all the financial risks. Limited parties are third-party providers of capital only. As soon as partnerships realise a profit after disposing of a company, the managing partners first deduct their carried interest, a percentage of the profit realised and their reward for running the partnership. Investments are pragmatic. "Some deals will involve buying all the equity in a company, others in taking only a minority of this under covenant," says Nicholas Ferguson, managing director of SVG Capital.

The problem for private investors is how to participate. Those with sufficient funds, at least some hundreds of thousands of pounds, can join a syndicate. The alternative is to buy shares in private equity investment trusts.

During 2004, the weighted average return on the 20 private equity investment trusts listed by the Association of Investment Trust Companies (AITC) was 11 per cent net of charges. This comfortably exceeded the 9.2 per cent return of the FTSE All-Share index. Returns varied widely. While 3i, the largest, grew only 6 per cent net of costs, HgCapital rose a spectacular 56 per cent, and the Prelude trust came second, up 47 per cent. Only two, North Atlantic Value from Enterprise Value and Hambrecht's Second London American, lost money.

But 2004 was a record year for disposals, and private equity is best seen on a 10-year view. Over the past decade, the best performer, Candover, has risen fourfold, with the second best, Graphite Enterprise, not far behind (see chart, opposite). Kleinwort was more typical, and 3i rather disappointing.

So, it is important to differentiate these trusts and build a diversified exposure. Candover invests on a pan-European basis, in deal sizes ranging from £750m to £1,250m. By contrast, Kleinwort invests only in the UK in deals from £10m to £30m. Graphite and Rutland are mainly in the UK, with deals worth from £40m to £65m. Schroder Ventures, Martin Currie Capital Returns, Standard Life Private Equity and Pantheon International invest in deals of more than £500m but are essentially funds of funds.

What of future prospects? "Current valuations in the large MBO stage look high in historical terms," admits Tony Langdon, chairman of the Rutland trust. "But," argues Ross Marshall, managing director of Dunedin Capital Partners, "there is less of this competition in the smaller deal sizes, where auctions are far less common and deals remain more reasonably priced."

Alan Ray, of stockbroker Panmure Gordon, says that "the argument for investing in private equity over 10 years or more remains strong". Ray's buy list includes Standard Life European and Pantheon International: "Both are core holdings for a private equity portfolio, funds of funds that offer real diversification by manager and geography. Both are also doing medium-to-large deals, the most liquid."

As an alternative, rich investors can join a private equity syndicate, organised by private banks or private family offices such as Coutt's or Fleming Family & Partners (FF&P).

"We have a lot of experience in private equity," explains David Donnelly, managing director of FF&P's private equity division. "Unlike new participants, we don't take part in auctions but find our deals by private referrals." FF&P's record is impressive. Highland Gold Mining, now Russia's third gold producer, floated on the Alternative Investment Market(AIM) in December 2002 at a 190p share price. "The original cost for our syndicate was equal to 48p per share," says Donnelly "so this has been successful by any standard."

The minimum commitment to FF&P's syndicate is £500,000, drawn down in tranches of 25 per cent when required. "If, after paying the first tranche, your circumstances change, due, say, to divorce, then you can decline further commitment without penalty," says Donnelly, "and we take up any shortfall." Its existing syndicate is closed, but this autumn it will start a new one with the intention of raising £40m. For investors large and small, private equity can be a fascinating and lucrative field - as part of a diversified portfolio.