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What is private equity? By Ceri Jones
Hardly a day passes in the City without new rumours of yet another company takeover target. Currently, around 30 formal bids for businesses worth £24 billion are up for discussion and another £20 billion of widely anticipated takeovers Some of the latest targets are big names such as Reuters (RTR), Yell Group (YELL) and even the giant Rio Tinto (RIO), which, if it merged with BHP Billiton (BLT), would create a mining Goliath worth $250 billion (£126 billion). The biggest private equity deal to date was sealed in February when the investment fund Blackstone (BX) won control of Equity Office Properties, an American landlord, for £19.7 billion. In the UK, the first FTSE100 company to fall to private equity could be the high-street icon Alliance Boots, recently the subject of a £10 billion bid from Kohlberg Kravis Roberts (KKR). A bid for supermarket Sainsbury's (SBRY) was scuppered in April by the Sainsbury-family, which controls around 18% of the supermarket and wanted to hold out for a better offer. KKR and other buy-out firms such as CVC Capital Partners (CVC) have since turned their attention to rival grocery chain William Morrison (MRW). The process typically involves a private equity fund-management firm raising a Limited Partnership fund, usually of 10-year duration, which buys stakes, usually majority, in businesses. The firm will often look for an established and defendable market position with strong cash flow, a plausible growth strategy and clear exit potential. The new ownership structure can supply the company with risk capital to accelerate its growth, organically or by acquisition, or to restructure. The private market also shields a company from the demands of shareholders to deliver an instant payback on any investment. The private equity manager actively helps the company to develop, normally by taking a seat on the board and providing strategic advice on capital markets and financing, market analysis, networking and sourcing other key executives.When the company has developed sufficiently to attract other investors, it may be sold to a larger company, floated on the stockmarket or sold to another private equity firm, which might be able to bring some other form of expertise to the party - surprisingly, 40% are sold on to other private equity firms. Private equity The term 'private equity' covers such a very wide range of diverse investment activities. Target businesses range from start-up ventures to the big, established listed companies that are hitting the headlines. Firms have different strategies, covering the sizes of investment, regions or countries in which they invest, specific industry sectors, or types of transaction such as start-up, expansion, buyout or recovery. While the term covers a broad spread of investment activities, as the underlying investments are always equities, returns are relatively correlated to the stockmarkets. And, in general, private equity returns have been well worth the wait, generating annual returns, net of fees, of 10.3% over the 10 years ended 2006. This is not far off double the figures for listed equities, when compared with the 5.5% annual return over 10 years in the Morgan Stanley Euro Equity index. Direct access to private equity funds is not easy for the small investor to achieve, as it usually means taking a big slug in one limited partnership, generally a minimum of at least £10,000. This is also an overly concentrated approach, and the investment is not liquid. An easier way for private investors to gain access to private equity activity is via a specialist investment trust, a closed ended listed fund run by a manager who invests in an array of limited partnerships on your behalf. This provides a spread of investments which is less risky than investing in a single venture. UK investment trusts There are currently 20 UK investment trusts specialising in private equity, although August Equity trust is merging with Rutland Trust (RUTA), and the management moved to New Star. New Star Private Equity investment trust (NSPE) will relaunch with £90 million of assets and will invest in private equity vehicles, primarily exposed to established mid-market buyout funds in the UK and Europe, putting the cash to work straightaway. The investment trust 3i (III) is one of the best ways to access private equity. The largest publicly traded European firm in the sector, 3i revealed annual profits of £1 billion for the first time in May. Its asset disposals included the recent sale of National Car Parks, which generated a profit of £267 million after just 18 months' ownership. The company confirmed that it will hand £800 million back to shareholders this summer. Some general funds also invest some of their holdings in private equity. For example, the investment trust Foreign & Colonial (FRCL) is increasing its exposure to private equity from 5% to 10%. Another way to access the market is via hedge funds specialising in takeovers, but these are even more expensive to access. However, the Financial Services Authority (FSA) has plans to make it easier for private investors to invest in funds of hedge funds. Conclusion Overall levels of return are likely to fall in 2007. More than £151 billion of new money was raised by private equity funds last year, forcing investors to pay higher multiples of earnings for target companies and funding deals with ever-greater debt. The average level of debt held by private equity-owned companies has soared from four times gross earnings in 2002 to nearly six times in 2006. So private equity managers need to be disciplined about the prices they are willing to pay and their return expectations. If you have no intention of investing in private equity, you might think the recent debates have nothing to do with you. But there is a good chance you are already invested. Pension funds have increasingly invested in private equity in the last few years as they divest away from publicly quoted equities. Interest has been fuelled by the strong performance of funds such as the Yale University endowment, which has generated nearly 40% a year from its private equity holdings over the past 10 years. However, Watson Wyatt, which provides pensions advice to over half the constituents of the FTSE 100, has said pension funds should steer clear of private equity unless they can access the sector's top-performing funds. The report argues that "some prices have become totally disconnected from fundamental valuations" and lenders have become too relaxed. So whatever your view on private equity - as takeover activity gathers pace and more UK blue chips are targeted - this is one area of the investment arena that will remain a hot topic in the City for some time to come.
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