Private equity is attracting its share of headlines. Although the focus tends to be on the multi-billion dollar buyout funds doing multi-billon deals, the reality is that private equity is going through a period of unprecedented growth. While the numbers aren’t final, it looks as though a record US$275 billion will have been raised in private equity in 2005, with the rate of capital-raising accelerating into 2006. In the first quarter of 2006, 110 funds closed, raising an additional US$80 billion.

Household names in the buyout space, like Apollo, Blackstone, Carlyle, Texas Pacific, Bain and KKR all raised funds between $8 billion and US$10 billion. In July, Permira announced that they had raised an €11 billion fund, the largest ever outside the U.S. The largest private equity investment last year was US$15 billion, in June of this year a US$22 billion transaction was announced. But for plan sponsors, the inner workings of private equity can be confusing. Still, it is an investment alternative well worth exploring and there are some very compelling reasons why so much new capital is being committed to private equity. WHAT IS PRIVATE EQUITY?
Private equity refers to pools of capital, typically organized as limited partnerships that make long-term equity and subordinated debt investments in both private and public companies. The partnerships typically have a life of 10 years, and the General Partners (GPs)who manage them seek investments with a horizon of five to seven years. Private equity investors normally have either a control position in their portfolio companies or significant influence, carefully defined by the provisions of a Shareholders’ Agreement. There are five principal types of private equity: venture, buyout, expansion, mezzanine and other. Other, not surprisingly, is a catch-all for strategies such as distressed, special situations, private investment in public equity(PIPEs) and secondaries. The other category represents approximately 10% of private equity. Buyouts are by far the largest category. These strategies include leveraged buyouts(LBOs)and management buyouts(MBOs). It is in this sector that most of the high profile, headline making transactions occur. The buyout category is often assumed to include growth or expansion capital. Buyouts and growth together represent approximately 60% of all private equity. Venture capital is the next largest category, at around a fifth of all private equity. Venture capital focuses on start-up or early stage businesses. Portfolio companies are often in the areas of technology, communications and life sciences. This is the Stephen Jobs starting Apple in his garage sector. Investment amounts are usually smaller, and spread across a larger number of investments, in recognition that many of the start-up companies will fail. Mezzanine funds utilize high-yielding subordinated debt to invest in established companies that have earnings and positive cash flow, but require additional risk capital. Mezzanine debt often includes warrants, preferred shares or other equity conversion rights. It is used for expansion, acquisitions, re-capitalization and MBOs and LBOs.

WHO’S BUYING?
Despite all the attention, and the success enjoyed by the leading Canadian pension funds with well-established private equity programs, private equity remains significantly under-developed in Canada.

The Greenwich Associates study Trends in Institutional Alternative Investing, published in November 2005, found that 42% of U.S. institutional investors were using private equity; in the U.K. the number is 17%. In Canada, they found that only 10% of institutional investors were using private equity. The average allocation to private equity for a U.S. institutional investor was 5.7%, for a Canadian investor it was 2.8%. Of the top 100 pension funds in Canada, just 32 have an allocation to private equity. Much of the investment in private equity in Canada is concentrated in a very few of the largest funds. The Ontario Teachers’ Pension Plan, for example, owns more than 10% of all of the private equity and mezzanine debt in Canada. An examination of the private equity returns realized by the large Canadian funds reveals just how powerful a contribution private equity is making to their overall portfolios. For example, with a portfolio size of $96 billion, the Ontario Teachers’ plan return on its entire portfolio was 17.2% while the private equity portfolio returned 31.4%. Similar results came in for other larger funds, with OMERS at 16.0% and 23.2% and Caisse de dépôt et placement du Québec at 14.7% and 29.8% respectively. The relative underdevelopment of private equity in Canada has had a predictable impact on the returns available. Over most intervals, the returns on Canadian buyouts have substantially exceeded those on U.S. buyouts. WHY DOES IT WORK?
The essence of private equity investing is insider information. Banned in public equity investing, the informational advantage that private equity managers get is crucial to their success. Private equity investors conduct exhaustive due diligence before selecting their portfolio companies. They will have detailed knowledge about the company, its management, products and markets, as well as the industry and the competition. Long before a deal closes, the GP will have a business plan and strategy agreed with management, a binding Shareholders’ Agreement and employment and incentive contracts in place with management.From the time the deal closes, the GP will have seats on the portfolio company’s Board of Directors. Private equity investors take a very long view, typically holding investments for anywhere from five to seven years, patiently adding value before the final exit. The illiquidity discount that private equity investors readily accept, narrows as the portfolio companies approach a liquidity event, whether it be a sale to a strategic buyer, an IPO or an income trust conversion. ASSESSING PRIVATE EQUITY
There are four approaches to building a private equity portfolio. They are a direct investment program, Fund-of- funds, fund investment and co-investment. Another option, secondary funds, is really a subset of fund investing. Each of these approaches has advantages and disadvantages, typically related to issues like resource requirements, cost, transparency, flexibility and return potential. In the direct approach, the fund recruits a team of private equity investment professionals and becomes its own GP, sourcing, evaluating, structuring and managing transactions on its own. It is common for direct teams like this to manage domestic investments on their own and invest in funds managed by other GPs for their international and/or specialist exposure. Participating in other funds also presents the opportunity for co-investments. In a fund investment program, the investor selects single-fund partnerships managed by one or more GPs. This allows the investor to focus on GPs who have been proven to be able to deliver superior results on a consistent basis and avoid the under-performing funds. A fund-of-funds strategy offers immediate diversification by manager, type and style and access to household names that might otherwise be closed. It is the least demanding of in-house resources. It also carries the least onerous due diligence requirements but has the highest cost and carry fees. In a co-investment, the investor is offered the chance to share in an investment sourced and structured by the GP, which may or not be in the fund in which the investor participated in order to secure co-investment rights. If the investment is in the fund, and the investor really likes it, he can obtain a greater exposure to the investment than his proportional share as a fund investor. If the investment is not going into the fund, the investor enjoys the benefit of a direct investment in a situation managed by the GP, without the corresponding demand on limited resources.

WHY INVEST?
Private equity has the potential for high rates of return. Top-quartile managers in particular can be expected to consistently outperform public markets. The persistency of returns means that selecting successful GPs over time has a high probability of building a high-performing private equity portfolio. The privileges enjoyed by private equity managers, including access to inside information and their ability to custom design investment structures represent advantages that are simply not available to a portfolio investor in public equity.

KEY CONSIDERATIONS
Get Started: It takes time to build a private equity portfolio. A program should include a number of managers, so it is important to get going now. Choose a Strategy: Pick the strategy best suited for your organization. For example, if you have all external management, building a direct team is unlikely to work. Go Mid-Market: Larger funds pursue ever-larger deals and end up chasing the same transaction and bidding up the price, thus eroding returns. The mid-market sector offers the most attractive risk/return relationships. Over-Allocate: Committing an amount equal to the policy target won’t get a fund to its target allocation. It is necessary to allocate between 1.5 and 2 times policy target to have a reasonable expectation of getting there. Be Patient: Private equity is true long-term investing. It can easily take five years or more before the returns to begin to emerge. Stay with Winners: As good managers are found, stay with them, and secure capacity rights for subsequent funds.

David Mather is executive vice-president with Integrated Asset Management in Toronto. dmather@iamgroup.ca

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