Small Cap Private Equity Investing in Uncertain Times

Nowhere is learning from the past more important than in private equity. Investments are long term, illiquid and exhibit a wide distribution of returns. In the current uncertain environment for private equity investment, investors must be asking themselves: 'Is now the right time to invest in private equity?' or 'Should I increase or decrease private equity commitments?' It's impossible to give definite answers to these questions. However, investors may benefit by following a set of key principles.

Principle one - private equity is 'equity'
This simple often forgotten concept causes many investors to conclude falsely that private equity is a diversifying asset class. Investors are often misled by the apparent low correlation between public and private equity. However, despite infrequent valuations, private equity tracks public equity over the medium to long term. The significant decline in public technology stocks over the last two years supports this view. Since last year, venture funds have been revaluing their portfolios downwards as a reflection of overall company values. Investors should consider private equity as a component of the fund's overall equity exposure rather than a separate asset class.

Principle two - balance buy-out and venture investments
Private equity portfolios should contain both buy-outs and venture capital, the two largest sectors of the private equity market. This allows for some diversification within a private equity allocation because there is a relatively low correlation between them. Industry evidence supports this counter-cyclical assumption. Venture capital investments tend to perform well in strong IPO markets, as evidenced in the late nineties. Alternatively, buy-out funds tend to perform better in weaker equity markets when they can purchase companies at lower prices.

Principle three - diversify by time
With typical investment periods of three to five years and fund terms extending to ten years or more, investors may not be concerned with when to invest. However, the industry focuses on vintage years and given that one of the key components of private equity returns is the entry valuation, an investor should euro cost average investments over time. This approach will help alleviate over-exposure to vintage years with high valuations. In the last difficult financing market of the early nineties where there was strong pressure on entry values, we observe the best buy-out returns in subsequent years. It is appropriate to compare today's buy-out environment with that of the early nineties.

Principle four - select experienced groups
Nowhere is manager selection more important than in private equity, and in venture capital especially. The last bear market for venture capital was in the eighties (when most European VCs did not exist). In this market, average venture capital fund returns were about five per cent, with top quartile groups returning approximately 12.5 per cent. The experienced groups defined as those with previous first quartile returns outperformed the overall top quartile managers of this bear market with a respectable return of 15 per cent.

Challenges of private equity in difficult times
However, buy-out and venture capital investments are not immune to difficult economic times. On the buy-out side, existing companies that are leveraged are squeezed as cash flows fall and coverage ratios decline. This makes default or bankruptcy increasingly likely. Budgets on which private equity investors based their investments may also be behind plan, and this reduces the expected rates of return. The duration of investments, or holding period, also increases as a limited IPO market and a lack of resources/interest from trade buyers make exits more difficult. Prospective buy-outs are also affected in difficult economic times as banks tighten their lending requirements. Less leverage implies less return, which must be offset by falling purchase prices that always take time to readjust downward.

On the venture capital side, a dramatic fall in IT spending, combined with massive investment in previous years has led many VCs today to spend a lot of time nursing existing companies rather searching for new opportunities. Significant capital raised by leading venture firms over the last two years implies that there will be fewer top venture capital funds coming to the market in the near term.

Applying the rules to today
There is still plenty of opportunity in European private equity, especially Central and Eastern Europe. Investors without a commitment already to private equity should find now a good time to start investing in the asset class. We believe that buy-outs currently have a slight advantage over venture capital, but we recognise the need to maintain a balanced portfolio.

Investors with an over-commitment strategy may find themselves reaching the top end of their private equity range as public equity fell faster than private equity and realisations on the private side slowed. Funds that face this situation may react quickly by exiting some or all of their private equity positions through a 'fire sale' in the secondary market. Long-term investors with successful programmes on the other hand have managed to avoid this.

So what should investors be looking at right now? Here is a quick checklist:

Buy-outs

1. Avoid funds that pay high multiples in efficient markets - the initial purchase price is a major factor in the total return of an investment
2. Avoid funds that shifted strategy in pursuit of short-term gains - many funds have invested in different areas from those that originally made them successful
3. Commit to funds with operating expertise - in a difficult financing market, high returns come from operational improvements, not simply leverage
4. Commit to funds with attractive deal flow not directly tied to the financing market
5. Commit to funds that have an investment discipline that avoids over-paying

Venture capital

1. Avoid funds with an existing portfolio of problem companies
2. Focus on groups with significant past venture experience, especially in the operating area
3. Commit to funds in which the GP has demonstrated a consistent strategy
4. Focus on groups with long-term venture capital experience and that lead deals - marginal players tend to be squeezed from down rounds of financing
5. Dollar costs average to avoid over-exposure to vintage years of high entry valuations.
6. Remain conscious of fund size and the ability to invest in a less capital-intensive investment environment.

Kevin Foong is senior partner at Courthauld Investments. Research and analysis conducted by senior associate, Alex James.