Among the options to be considered, alternative investments should loom large. More and more, investors around the world are considering this asset class because of its attractive returns and low correlations to other investments. These characteristics make alternative assets, particularly outside Canada and the U.S., worth a closer look, especially when plan sponsors in Canada look to enhance returns, diversify their investments, and address funding challenges.
WHY PRIVATE EQUITY?
As evidenced by the flood of capital responding to fundraising efforts by well-established venture capitalists and other private equity investors, one of the more attractive areas within alternatives is private equity. A private equity portfolio can be loosely defined as one that invests in companies not publicly traded on an exchange. Such investments typically involve the creation of value by accelerating a company’s growth, by streamlining a company’s cost structure, or a combination of both.
Managers who invest in private assets generally try to leverage their operational expertise to improve a company’s bottom line, whether through the implementation of cost savings, a more aggressive business approach, or the strategic acquisition or disposition of company assets. Confronted with the potential for greater risk and lower liquidity inherent in private equities, investors expect higher returns than those found in public equities.
International private equity can be particularly attractive for several reasons. First, as with any international investment, it provides regional diversification. Second, many international private equity markets have produced highly competitive returns over recent time periods. For example, according to the most recent data available, for the five- and ten-year annualized periods ending December 2004, European buyout transactions yielded 5.7% and 12.5%, respectively, compared to returns of 2.3% and 8.4% for their U.S. counterparts, according Thomson Venture Economics/ NVCA/ EVCA.
Third, international private equity capitalizes on two important macro trends—regional consolidation, particularly in Europe, and globalization—which have created many interesting opportunities for investors in this asset class.
Global private equity buyouts have rapidly increased since the mid-1990s and growth in overseas buyout activity is likely to continue, with global markets placing increasing emphasis on shareholder value. Furthermore, there is a growing need for and acceptance of private equity transactions on a worldwide basis.
As private equity investing has grown in size and visibility around the world, companies have come to accept that private equity firms are credible buyers who can reliably complete a transaction. Increasingly, sellers seek out private equity firms because they are perceived to be able to close deals quickly and because sellers wish to avoid selling assets to strategic rivals. Investment banks advising corporations on merger and acquisition transactions are also satisfied with the ability of private equity firms to consummate transactions reliably.
REGIONAL TRENDS
Regional trends around the world are also aiding in the development of global private equity markets. In Europe, for example, unified markets and common currency have shifted the economic balance in favor of investment and borrowing, interest rates are relatively low, monetary policy is somewhat more independent of national political interests, and the single currency provides access to deeper and more liquid pools of capital.
Private equity investment opportunities are also growing in Latin America. Mexico is a beneficiary of the North American Free Trade Agreement and enjoys a relatively stable economy, growing access to credit, an investment- grade rating on its sovereign debt, and a large, emerging middle class. Brazil and Argentina also offer attractive private equity opportunities, particularly for investors with specialized underwriting expertise and established deal-sourcing relationships. In the aftermath of economic upheaval in Argentina and the instability of Brazil’s political situation, these two countries fell out of favor with many investors. As a result, despite a strong rebound in these countries’ local stock markets in 2005, there are still many companies in Brazil and Argentina with an unfulfilled need for financing and attractive assets available at reasonable prices.
In Russia, another country where public market returns were strong last year, additional opportunities in private equity are emerging. Since undergoing a financial crisis in 1998, Russia has enjoyed increasing political and financial stability supported by higher oil prices, growing consumer demand, and improved fiscal policy. In this environment, businesses focused on growing consumer demand here may also provide sound investment opportunities.
Finally, Asia, which contains the second-largest economy in the world—Japan—as well as many rapidly developing economies, offers its own multitude of private equity investment options. Japan is emerging from over a decade of economic stagnation and, although the Japanese private equity market as a percentage of its gross domestic product is paltry compared with the United States or Europe, buyout activity has grown dramatically. In addition, several other Asian countries are witnessing the emergence of a young middle class with growing discretionary income.
These economies remain largely export-driven, but the growth of the middle class appears to be laying the groundwork for increased domestic demand for goods and services. This catalyst should lead to new opportunities for investing in companies that serve these markets.
GROWING POPULARITY OF THE ASSET CLASS
Given its attractiveness and growing acceptance, more institutional investors are making or increasing international private equity allocations. Over the past five years, a tremendous amount of capital has poured into private equity funds, fueled by investor demand and low borrowing rates.
The abundance of capital due to investor interest, readily available and inexpensive debt, as well as the greater use of investment consortia, has facilitated historically large transactions. The leverage employed in many deals today has also added risk in the private equity market.
As usual, in any market where capital abounds, lack of investor discipline can be a concern. However, higher interest rates may squeeze market liquidity by making leverage more expensive, thereby limiting transactions that derive value simply by refinancing existing businesses. This means that investors must remain disciplined and become even more focused on operational efficiencies and earnings growth. Investors may also need to be prepared for longer holding periods and lower expected returns.
The maturation and growth of the industry also means that investors have more options available for accessing private equity. A common option is to invest in pooled vehicles, which allows institutional investors to create diversified portfolios by making commitments to multiple single-manager funds. Other investors, particularly those with smaller private equity allocations, may utilize a fund-of-funds approach, which provides manager and investment diversification but inserts an extra layer of fees in the process.
A less common, yet still attractive, variation on the single manager fund is one that invests directly in private companies alongside other private equity funds. This approach provides an extra level of due diligence to each transaction and adds diversification to the portfolio. Such funds offer a fee structure similar to that of a single manager fund and avoid the extra layer of fees found in fund-of-funds.
The growth of international private equity investing has introduced a new set of issues for prospective investors to consider. Nevertheless, with its potential for strong returns and diversification benefits, it deserves its place as a key performance enhancing asset class in any well-balanced and diversified portfolio.
With the elimination of the FPR, Canadian plan sponsors should reconsider asset allocations with a specific emphasis on foreign investments. International private equity will be a valuable option for Canadian investors as they seek to meet their investment goals in this new environment.
Jim Mara is senior vice-president, International Alternative Investments, GE Asset Management in Stamford, CT; james.mara@ge.com
