In the UK there are over 4,300 private-equity backed companies – more than double the number of listed companies – while the number of listed companies has shrunk by 40 per cent over the last 20 years.
During this time, private equity as an asset class has been expanding rapidly, especially over the last decade, and so has institutional investors’ allocations to it.
Oliver Gardey, head of investments at the £747.5m ICG Enterprise Trust, pointed out that surveys show 80 to 90 per cent of sophisticated investors are maintaining or increasing their allocation to private equity despite the pandemic.
The private equity market, he argued, is more closely linked to the real economy than public equity markets. After all, the FTSE 100 is concentrated around financial services, energy, resource extraction, tobacco and alcohol, while the S&P 500 is dominated by a few of big tech names.
Gardey argued that given the sheer number of private-equity backed companies, the stock markets offers reduced choice for investors and, without exposure to the private equity market, an investor doesn’t have complete exposure to the whole equity market.
For retail investors, however, private equity can be very hard to access. There are high minimum commitments, where typically £5m and above is required, and money often has to be locked in for 10 years with no liquidity.
Yet this is where listed private equity comes in. “It democratises a very hard to access asset class and provides that bridge for the retail investor to get access to something that the big sovereign wealth funds, pensions schemes, etc, are increasing their allocations to,” added ICG Enterprise Trust managing director Colm Walsh.
20-year performance of ICG Enterprise, IT Private Equity and FTSE All Share
Source: FE Analytics
Indeed, over the past 20 years, the average trust in the IT Private Equity sector returned 146.34 per cent, beating the FTSE All Share’s return of 116.72 per cent. ICG Enterprise delivered total returns of 315.16 per cent over the same period.
Gardey credited the excess returns of private equity to its active ownership model which drives operational and strategic improvements in companies.
“When you look at private equity returns, they are driven by the exits, and by operational and strategic improvement,” he said. “There’s also some benefit coming from leverage, but most of it comes from operational and strategic improvements.”
He also believes a lot of outperformance comes from the alignment of interest between the fund manager and the investors.
Private equity fund managers often invest a lot of their own capital, only generate wealth after they have received an 8 per cent hurdle and only get it when the exit is realised. Gardey contrasted this to a public equity market manager, who gets paid every year depending on the NAV of the fund.
“The alignment of interests between private equity managers and investors fosters certain behaviour where they only can generate returns if they transform a good business to a better business or a regional business to a global business,” he explained.
“They need to really get into the company and strategically and operationally change things. It’s not just financial engineering which obviously helps too, to make the company more financially efficient, but also bringing in operational improvements to transform them into best-in-class companies.”
On the other hand he said many public companies that may want to modernise the business cannot reinvest, or set up new ideas, or build a new plant because they may be too heavily judged on quarterly earnings and pressured to return capital to investors through share buybacks or dividends.
While private equity returns have beaten public markets, Gardey added: “It has one big issue – it's also the most risky asset class when you measure it by the gap between top quartile and bottom quartile managers.”
“The gap from bottom quartile to top quartile is bigger than any asset class, therefore the ability to access the top managers becomes incredibly important.”
He said that the trust’s ability to access the top performing funds and managers makes a meaningful difference to how the private equity portfolio performs.
“If you don't think about how to avoid the bottom quartile, then you can get into trouble. So our strategy is all about managing that risk return equation,” he explained.
ICG Enterprise focuses on buyouts on companies that have prudent cash flows, are market leaders or have a strong market position.
It tries to avoid venture capital or growth capital because of the significantly higher risk affiliated with those strategies.
“Typically in venture and growth capital, you have somewhere between 60 to 70 per cent loss ratios, versus in buyouts you’re around 15 per cent, and the best buyout shops have below 10 per cent.” Gardey revealed. “That’s why we are entirely focused on buyouts.”
Of the listed private equity trusts available to investors, many are either funds of funds or are effectively feeder vehicles for direct single funds run by a single manager.
“In funds of funds, you have a lot of diversification but we think actually you almost over diversify because you’re getting exposure to effectively over 1,000 companies,” Gardey said.
“On the other funds, you can pick some great companies and have done very well, but it is very concentrated around one manager and a handful of companies which are really driving the returns of the fund and the listed trust.
“Therefore the issue there is you have a high concentration around the fund manager and industry sectors.”
ICG Enterprise invests half directly into companies managed and sourced by top-tier managers as a co-investor, and half as fund of funds.
Gardey said this allows the trust to build a portfolio around the sectors and type of companies it wants to invest in and proactively select portfolio composition.
“That is part of the secret sauce of why we have weathered the storm so well over many cycles,” he finished.
Performance of ICG Enterprise versus sector and FTSE All Share over 25 years
Source: FE Analytics
Indeed, the ICG Enterprise Trust has returned 1331.48 per cent through three economic cycles over the last 25 years.
This is compared to the average trust in the IT Private Equity sector, which returned 544.56 per cent, and the FTSE All Share’s 361.28 per cent over the same period.
The trust is trading at a 27.1 per cent discount to its NAV, is not geared and has an ongoing charge of 1.37 per cent, according to data from the Association of Investment Companies (AIC).