The Myners Review highlighted the investment duties of pension scheme trustees. One of its recommendations was that the trustees should look at investing in a full range of asset classes, including those under the ‘alternative' umbrella.

What is private equity?
The term alternative assets describes non-traditional asset classes. They include hedge funds and property and they are generally more risky than traditional assets. They also include private equity. This is the term applied to investments in private companies (those not listed on a stock exchange). There is often confusion surrounding the definitions of private equity and venture capital. Broadly speaking, private equity refers to the asset class as a whole and includes seed capital, venture capital, expansion capital and management buy-outs. Many private equity funds specialise in one or more of these investment stages.

What are the stages of investment?
The first stage is for specialist investors who provide seed capital. This is the provision of very early stage finance to companies with a business venture or idea that has not yet been established.

Venture capital is the investment in start-up companies that have the potential to grow rapidly and develop. Venture capitalists often become involved in the provision of capital to a company when it enters the production and growth stage, although it may not be making a profit yet. This is second stage funding. In recent times, venture capitalists have concentrated mainly on investing in high-technology companies because this sector has had potential for very fast growth.

Private equity funds also provide expansion capital. This is financing for established companies that need funding to take them through a growth phase, such as setting up new offices or moving into new markets.

The most established form of private equity funding is management buy-outs. In this type of investment, private equity firms provide finance to management teams in businesses that wish to buy either the whole company or the subsidiary that they operate. This usually happens either because the management feels it can develop the company better or more rapidly under its leadership than with its existing shareholders or because a large company is selling off one of its subsidiaries to concentrate on its core activities.

How do private equity funds realise their investments?
In return for their investment, private equity funds take a share of the company. They realise their investment when they decide to sell it to another party. The sale of that share is known as an exit, or more rarely, as a liquidity event. The most common exit routes are initial public offerings, trade sales and secondary buy-outs in which the fund sells its stake to another financial buyer. In some cases, the company may even buy back the private equity investor's stake. Investors in many cases have the power to force a company to sell up so that they can exit the investment, but the exit is usually agreed with the company's management team.

Can all pension funds invest in private equity?
Trustees who wish to invest in venture capital first need to check their trust deed and rules to ensure that they have the power to do so. Provided that the trustees have the power to invest - and most recent pension scheme deeds usually give that power - then this should not be a problem. Where they do not have the power to invest, then an amendment to the deed will be required.

What are the key incentives to invest in private equity?
The main reason for investing in private equity is the level of risk-adjusted returns. Provided that a pension fund chooses the right private equity manager(s), it can receive significantly higher risk-adjusted returns on its investment than in other asset classes. The funds raised in 1994 have so far returned on average 36.9 per cent a year, according to the British Venture Capital Association's figures. Admittedly, this is exceptional, but the same source quotes net annual returns to investors over ten years to December 2000 as 20 per cent.

Increased information is another reason. By investing in private equity funds, pension funds can increase their knowledge of companies, industries and sectors. This may be of use when considering investments in other asset classes.

What are the differences?
Investors in private equity funds should be aware that they are committing their money over the long term. The funds have a set lifespan, usually set at ten years. Investors may not start seeing any returns for three to five years and will not receive full returns until the end of the fund's life. If a pension fund needs liquidity, private equity may not be a suitable investment.

Reliable performance statistics on specific funds can be difficult to obtain and they are not comparable with quoted equity returns. New investors complain about a lack of transparency about performance figures, which are open to interpretation. However, the British Venture Capital Association is campaigning for transparency. Its aim is to receive performance statistics from 100 per cent of its members (at present it claims that only 96 per cent comply although this is higher than their European counterparts).

Fees are much higher in private equity than in other asset classes. Investors pay an annual management fee of between 1.5 per cent and 2.5 per cent to the private equity fund. Managers also take a share of the profits they make on investments of around 20 per cent. This is known as carried interest. This may seem steep compared to other investments, but managers argue that the much higher returns more than compensate for this. They also point to the fact that investing in private companies is much more time-consuming, specialised and risky than investing in public equities.

Where next?
Myners recommends in his review that ‘the BVCA should continue an active dialogue with the UK institutional investor community to educate investors about the validity of valuation techniques and to respond to any emerging concerns about the use, non-use or abuse of the BVCA's own guidelines'. Chapter twelve of the Myners Review, ‘Private equity', should be compulsory reading for trustees considering alternative investments.
As with any investment, trustees have to be able to identify managers that are likely to outperform quoted equity markets. They also need to be informed and comfortable about the additional risks they would run.

Trustee education is the key and there are no shortcuts to this. Myners recommends in his review ‘funds and their sponsors should increase their investment in training for trustees'. Pension managers and advisors are now attending courses on alternative assets. This is all very well. But it is the trustees who are responsible for the final decision and they need to be trained well in advance of their advisors making a recommendation.

Terry Johnston is a director of Alexander Rae. He was formerly a director of the Electricity Supply Pension Scheme and a trustee of the PowerGen Group of the ESPS for 16 years. As a director of the corporate trustee of the ESPS he acted as chairman of board committees, dealing with key investment issues and senior scheme appointments. Telephone: 01522 501209, e-mail: terry.johnston@alexanderrae.co.uk

Alexander Rae offers a different approach to independent trusteeship. We bring experience that is particularly valuable to schemes where they may welcome an experienced and independent voice around the table able to assist trustees in identifying and considering key issues. We also provide consultancy services to fund managers using our experience of one of the UK's largest pension schemes. www.alexanderrae.co.uk

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