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Taking a different path

Private equity's success and growth has so far been dependent on the growth in corporate values. That's fine when public markets are booming, but it's problematic when they're not. Daniel R Revers of ArcLight Capital Partners sets out his vision for a new type of private equity – investment based on asset values.

The private equity market has enjoyed extraordinary growth over the past 25 years. It has perhaps even outgrown its ‘alternative investment' category that has been used to distinguish it from the traditional public equity and bond investments. From its earliest origins after World War II, private equity has been one of the fastest growing institutional investment classes. With private equity funds consistently delivering returns in the 25 per cent range up to the late 1990s, interest in the asset class soared. Pension funds, endowments, insurance companies and banks all sought the pot of gold at the end of the private equity rainbow. The sector peaked in 2000, with annual capital commitments to private equity funds topping an estimated $140bn.

The primary driver behind these private equity fund investments was corporate values - the difference between what the markets said the company was worth at purchase and what the market would pay for the company at exit, usually via an IPO or trade sale. This strategy delivered attractive returns to investors as the NASDAQ grew and pushed 5,000 and M&A volumes reached record levels.

But then the stock markets crashed. Corporate valuations plummeted and the IPO and M&A markets were virtually eliminated overnight. This proved disastrous for private equity funds. Investors, whose portfolios were laden with overlapping buy-out and venture funds, saw returns dive. Since then, the traditional ‘top quartile' private equity funds from the late 1990s have delivered lower than ten per cent returns to investors - a far cry from the anticipated 30 per cent to 40 per cent.

There is another way
Of course, the recent fall in the public markets doesn't mean the end for private equity. The public markets will inevitably rebound, and again provide upside for traditional buy-out and venture capital investments. But in the meantime, a small number of private investment firms are taking a decidedly different approach to private equity investing. This new path for private equity departs from the traditional model in some important ways:

1. Deal structure/investment thesis
The traditional private equity deal is structured around corporate value rather than asset value. Returns are driven by such intangible factors as improving margins, increasing sales, maximising leverage, exploiting technologies, hiring better management, and exploiting exit value arbitrages. This approach requires some guess work. Guess right and returns are very high; guess wrong and you may lose some or all of the original investment.

The new approach to private equity deals focuses more on asset value and cash flow. Returns are driven by the actual cash flow distributed to investors by a single or a group of tangible assets, and also by exits at salvage value, replacement cost, or ‘yield to new investor' (a securitisation-type asset value.) Unless something goes terribly wrong, the investment will achieve its projected return. Market sectors particularly well suited to this type of deal include asset-rich industries such as power, energy, and real estate.

2. Returns profile
The value in a traditional private equity deal is generated almost exclusively from the exit. This model works well when there is a vibrant M&A and IPO market in which companies can cash out. With no IPO market and a tough financing market for M&A deals, the customary exit opportunities for traditional private equity deals have been delayed or, in some cases, eliminated altogether. In any case, delaying exits when returns are 100 per cent dependent on such events increases investor risk.

Alternatively, private equity deals structured around assets and cash flow typically generate significant current returns in addition to capital appreciation. The current return component allows for a longer investment horizon, greater visibility into total returns, less pressure to time exits, and multiple exit strategies.

3. Underlying Asset Value
When the stock market values of once-attractive tech and dot-com companies dropped, investors in traditional private equity deals were left with almost nothing of value. Private equity deals based on asset value, however, provide a measure of protection from gyrations in the public markets. As the public market value of once powerful energy giants Dynegy, Williams, and El Paso evaporated, the value of individual assets these companies owned held up well. This is evidenced by Berkshire Hathaway's purchase of Dynegy's Northern Natural Pipeline, Loews'purchase of Williams' Trans-Texas pipeline, and Goldman Sachs' recent purchase of El Paso's Linden Cogeneration Facility.

By taking a different path, asset-based private equity investments can deliver the same high returns generated by corporate structures. At the same time, these deals provide a level of downside protection with a measure of security of principal unavailable from corporate-style deals.

This new path for private equity is not for every industry or every investor. But asset-based deals with strong underlying values and multiple exit strategies are an attractive alternative for many private companies seeking capital and for investors seeking strong returns with a lower risk profile.

Daniel R Revers is co-founder and managing partner of ArcLight Capital Partners, a Boston-based private investment firm focused exclusively on the electric power and energy sector.

Copyright © 2003 ArcLight Capital Partners