Private Markets Escape “Investor Sentiment” Trap

Coverage of the 2011 Investment Innovation Conference.

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kleenex boxThe past three years have presented investors with significant market challenges that have left them with “nowhere to hide,” as The Economist so aptly illustrated on a recent cover. As institutional investors search for proven and sustainable solutions to meet their long-term funding objectives, investments in private equity and infrastructure stand out as compelling options to generate returns that exceed those available through conventional public equities and fixed income. In the context of a low-growth environment, both the structural benefits of the private markets fund model and the patient, long-term focus and investor-aligned mindset consistently demonstrated by leading private markets managers are intuitively appealing. Further, investment innovation – the application of an existing concept in a novel way to meet a specific, consumer need – can be found in the recent success of investor-focused private equity and infrastructure managers in creating cost-effective, professionally managed private market platforms to generate incremental long-term returns for institutional investors.

The private equity model, in particular, has key structural advantages that enable it to deliver attractive long-term results during periods of low growth and limited multiple expansion. When successfully implemented, private equity is characterized by three primary sources of value creation that distinguish it from other asset classes:

  • a focus on long-term results through direct and active ownership of private companies;
  • involved boards and a strong alignment of interests between management and investors; and
  • a reliable funding model through the committed capital structure of a private equity fund.

These structural advantages underpin the demonstrated ability of private equity managers to grow revenue and improve earnings margins through operational improvements, which is critical at a time when normalized P/E multiples remain relatively high while future growth prospects remain uncertain.

Unencumbered by the vagaries of broad investor sentiment and insulated from the relentless pressure of quarterly earnings reports, private ownership enables investors to drive significant changes in strategy and operations, which translate into sustainable profitability gains. Furthermore, a private equity manager’s ability to support promising portfolio companies with patient sources of capital allows for a longer-term perspective on capital allocation decisions and, significantly, control over the timing and manner of exit. While initial public offerings are often perceived as the most lucrative exit route for private equity managers, trade sales and strategic acquisitions continue to provide attractive exit options and are likely to continue to do so given the significant cash accumulating on corporate balance sheets.

Despite current market conditions, there remain buying opportunities for those with capital to invest in the private markets, as a result of reduced deal competition, distressed/motivated sellers and lower valuations in select market niches.  However, successful implementation remains the key to achieving long-term outperformance.  A professionally managed program offers significant sector and geographic diversification, but access to the best fund managers remains imperative. There is a wide dispersion of returns amongst private equity managers and access to the very best managers continues to be difficult for new investors. Designing and building a profitable, diversified private equity program is time-consuming and challenging – and beyond the scale and resources of many institutional investors. However, successful fund managers and advisors have built global teams, successful track records and a compelling value proposition that can deliver attractive net returns to investors through commingled funds and segregated accounts tailored to meet their individual investment and governance objectives.

While the global capital markets headlines remain grim, Canadian institutional investors of all sizes have numerous, increasingly innovative investment options available to them as they seek to diversify their portfolios and access the long-term value creation opportunities available through hands-on, active ownership of private companies.

Stuart D. Waugh is Managing director & Managing partner, Northleaf Capital Partners.

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