There is no such thing as a free lunch. Its one of the laws of the universe, just like that other law: private equity investment is risky. During the late 1990s, average returns from US venture capital reached over 150 per cent a year, or so the valuations said. In the last two years, these same funds are down by over 50 per cent with more bad news on the way. That’s enough to cause indigestion even for the strongest investor.
Remember, despite poor returns, venture funds continue to accrue fees on full commitments — that is, before they are utilised by the venture capitalist. Furthermore, as the funds draw down, investors are contractually bound to provide that capital. Investors are locked into this arrangement, usually for a decade.
In the US where commitments to private equity are significantly higher than here, allocations like 10 to 25 per cent are not uncommon. With these levels, large valuation changes make it very difficult for an investor to maintain planned weights across asset classes because there is virtually no hope of trading the private equity portfolio. An important constraint for any organisation developing a private equity program is its illiquidity. You can’t get enough of it, and you can’t get rid of it. You simply balance allocations as best you can while prevailing upon a patient sponsor board.
Fortunately, here in Australia, private equity weights typically remain at low levels, with the average institutional allocation being only 2 to 3 per cent of total funds under management. For the moment, this may appear fortuitous. However, with private equity promising such a long-term premium to other asset classes, and a vocal industry pledging further commitment, is this about to change?
First, why are allocations so low? It may simply be that the Australian institutional private equity market is relatively new. As with other new asset classes, investors may dip their toes in the water before taking the plunge. However, it is a well understood feature of private equity investment that J-curve returns are prolonged if money is trickled into the sector. For example, having suffered the poor returns of the first three years of a small initial investment, any payoff is swamped by the J-curve from subsequent greater investments. The prudent approach is instead to invest boldly and as quickly as possible.
A more robust explanation of low allocations involves the very illiquidity mentioned above. Overseas, large university endowment funds or mutual assurance companies can take longer views and reap substantial rewards from bearing illiquidity risk. Australian institutional investors, however, are increasingly accumulation-style super funds exposed to short-term retail comparisons. This may ultimately set a limit on the size of assets invested in Australian illiquid sectors.
When taken together with direct property, the even more illiquid private equity sector probably represents a concern for accumulation fund boards. For example, say the out-performance of private equity is so attractive that those schemes with higher allocations do well against competitors. Members flock to that option, thereby diluting the relatively finite allotment to the very asset that brought success. Conversely, a board left high and dry with an illiquid private equity allocation unable to exit for the best part of the next decade is an equally distressing image.
Whether it is choice of option within a scheme or the flickering spectre of full fund choice legislation, any board which can not count on the stable patronage of members should keep an eye on liquidity. Such a board would naturally question binding its successors with a decade or more of heavy exposure to an illiquid asset class like private equity.
The choice seems to be either indigestion for investors or a headache for the local private equity industry. Note the impassioned plea from Australian venture capitalists for smooth tax treatment of overseas investors.
If Australian institutional allocations remain low, the question has to be asked if a mere 2 or 3 per cent in private equity is material enough to affect total scheme returns at all. This is a pressing question when we hear of so many boards spending a disproportionate amount of effort on a time-consuming, hands-on private equity portfolio.
Nonetheless, private equity remains a sector with some enthusiastic support. It is strange to have a consensus of rhetoric in favour of private equity while there is another consensus of inaction for making meaningful allocations.
The rhetoric seems borne out by schemes that have taken the plunge. The consensus is that long-term private equity is worth the trouble: the trouble of finding it, the trouble of prolonged draw-downs, the trouble of high fees and the trouble of illiquidity. But this consensus only brings us back to the first question: if it is worth the trouble, why so little invested?
Australian accumulation funds, it seems, are taking plenty of liquids with their private equity free lunch. Perhaps you get fewer headaches with a liquid lunch than you do with a free one!
— David Brown is senior fund manager at the Queensland Investment Corporation.
