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participants
This page considers participation in private equity funds:
where do they obtain money for buying assets.
It covers -
 introduction
It is clear from the preceding page of this note (and
from the benchmarks elsewhere
on this site) that private equity funds hedge
fund have been able to deploy awesome amounts of capital
for acquisition of enterprises, real estate or other assets.
Where does that money come from?
The answer to that question has varied over time, by fund
and by jurisdiction (reflecting for example different
tax regimes, restrictions on participation by particular
classes of investor and even cultural factors such as
emulation of peers or institutional distaste for 'flip
& flee' fund promoters).
Overall we can distinguish a range of participants -
- private
equity fund managers - demonstrating a commitment (and
ideally gaining further rewards) by contributing capital
rather than merely packaging deals and managing the
transition from acquisition to dismemberment, sale or
IPO
- corporate
superannuation funds - aka corporate pension funds (CPF)
- seeking substantial returns to finance health and/or
retirement payments to current or former employees and
their dependants
- endowments
and foundations - philanthropic trusts and not-for-profit
private sector entities such as universities seeking
to optimise investment revenue
- insurance
companies
- banks
- public
investment funds (including Public Pension Funds)
- individuals
and families - people of 'high net worth' wanting to
diversify an investment portfolio or gain higher returns
than are provided by more traditional investments
The
shape of that participation - including restrictions on
entry/departure from a particular fund, special rewards
for some participants and constraints on the activity
of managers - varies from fund to fund.
As mentioned in the preceding page of this note, it reflects
factors such as -
- the
profile of the manager ('stars' tend to adopt a 'take
it or leave it' stance)
-
the fund raising environment (large amounts of capital
flowing into the sector in 2006 compared to late 2001)
-
whether an investor enters the fund at the beginning
or at the end of solicitation for capital (early entrants
receive better terms than laggards)
-
the prominence or sophistication of potential investors
(eg 'blue chip' institutional investors often get special
rates)
- the
size of the fund and the scale of contributions (eg
some funds require a minimum participation by institutional
investors of US$50m)
- whether
the manager has a stellar profile (in terms of both
above-average returns and positive media coverage),
is less impressive or is simply unproven
- whether
the investor has dealt with the manager in the past
and secured 'grandfather rights' of early access when
a new fund is being raised.
In
general the creation of a fund involves negotiators dancing
to the music of money, with a different tempo and tune
each time. Managers prefer to 'partner' with investors
that are 'professional' (aka realistic or merely undemanding),
that facilitate solicitation by bringing corporate/personal
lustre to the fund, that will not cause difficulties by
seeking an unscheduled exit and that will enable optimisation
of the manager's interests. Investors similarly balance
perceptions of risk and reward, considering the commercial
track record of the manager, special conditions and reputation.
In contrast to public equity, managers can pick and choose
their partners; investors can pick and choose the funds
on the basis of the managers. Some large investors are
accordingly investing capital in a range of funds operated
by competing managers or taking stakes in successive funds
operated by a particular manager.
fund
managers
Some fund managers contribute capital to the funds that
they manage, with an expectation that they will be directly
rewarded through growth of that capital rather than merely
through a succession of fees levied on other participants.
Such participation is typically marketed as an indication
of commitment ('we believe in this offering enough to
put our own money at risk') and as a demonstration of
the manager's credibility (the assumption being that the
money was generated by participation in past funds or
fees).
It is thus analogous to past merchant banking practice,
where elite banks such as JP Morgan contributed some capital
of their own (ie of their partners) when aggregating finance
from different sources for industrial or property development.
Capital contributed by managers may be drawn from their
individual resources (eg inherited wealth or money accrued
through past deals). It may also come from a corporate
parent such as a merchant bank.
superannuation funds
Superannuation funds - aka corporate pension funds (CPF)
- and mutual funds now own most shares in listed corporations
in major economies other than China, Japan and Russia.
Super funds receive periodic contributions from employees
(and often from employers), using income from that pool
of capital to pay retirements and other benefits that
supplement government welfare schemes. The pool can be
significant: the UK Universities Superannuation Scheme
for example has funds of £20bn
Their participation in private equity varies, depending
on their sophistication, size and regulatory constraints.
Some seek to balance highly conservative and long term
investment by taking stakes in entities that provide higher
returns in the short to medium terms. Those entities include
hedge funds, venture capital and private equity funds;
pension funds also sometimes take a direct involvement
in corporations and in property development.
Major pension funds are often sophisticated investors,
given the resources at their disposal and their continuity.
They may thus place less reliance on external professional
advisers. As a result their participation is sometimes
considered by equity fund managers as a signal of credibility
or quality and it appears that particular CPFs have secured
marginally lower participation fees. During 2005 US funds
are reported to have allocated an average 7.6% of their
total assets to private equity. Blackstone Group indicated
in 2006 that 48% of its capital came from state and federal
government pension funds.
Endowments
and Foundations
Philanthropic foundations encompass endowed not-for-profit
entities that make grants to third parties, that operate
facilities such as hospitals and museums, or that design
and implement their own programs rather than giving grants
to others. They typicall enjoy substantial tax privileges
and have the advantage of corporate continuity.
They have attracted attention for the size of their capital,
with for example the Robert Bosch Stiftung having assets
of €5.1bn, the Ford Foundation some US$10.6bn, the
Wellcome Trust £11.6bn, Volkswagen Stiftung €2.4bn,
Howard Hughes Medical Institute US$14.8bn, Robert Wood
Johnson Foundation US$9.4bn, Kellogg Foundation US$6.3bn,
Packard Foundation US$6bn, MacArthur Foundation US$4.5bn,
Nature Conservancy US$802m, Hertie Stiftung €820m,
Calouste Gulbenkian Foundation €2.5bn and Mellon
Foundation US$4.5bn.
Other entities also have substantial resources. The US
arm of the Salvation Army has upwards of US$2.2bn, the
Memorial Sloan-Kettering Cancer Center with US$1.9bn and
the Metropolitan Museum of Art - the rich persons' club
in New York - has a respectable US$2.1bn. Educational
institutions may also enjoy endowments. Among universities
for example Harvard has an aggregate endowment of US$25.2bn
as of 2006, Yale US$15bn, Stanford US$12.2bn, Princeton
US$11.2bn, Columbia US$5.2bn, Chicago US$4.1bn and Oxford
£5.1bn. Melbourne University had $908m as of 2005,
somewhat less than Phillips Exeter Academy in the US.
Leading endowments are likely to be major participants
in private equity funds, given the capital and their disposal,
an activist approach to maintaining investment portfolios
and the sophistication of their own managers/advisers.
Constraints reflect the terms of particular endowments
(some trustees rue restrictions imposed by donors, which
has resulted in lower capital growth than that of peers)
and even legislation that seeks to curb adventurism. Rationales
for participation vary.
Some endowments are particularly hard-headed: involvement
in a fund potentially offers returns that are better than
the overall stockmarket (a challenge when the endowment
is so large) and that because it typically comprises between
2% and 15% of the endowment's portfolio does not pose
an unacceptable risk.
Others participate because direct involvement in shareholding
would be politically fraught (for example contrary to
an institution's ethical investing policy) or because
appropriate remuneration of inhouse managers would provoke
disquiet (academics for example have complained that the
managers of a university endowment earn ten times the
salary of a tenured professor).
Public
Investment Funds
Some financial analysts group Public Pension Funds (PPF)
with Public Investment Funds (PIF) - aka Sovereign Wealth
Funds (SWFs) - as
a discrete category of participants. It is a categorisation
that has found favour in the US but in other locations
is regarded as less persuasive.
PPFs typically involve superannuation funds for government
employees. Those funds may considerable: in the US for
example the Californian state CaLPERS scheme has US$214bn
under management, of which around US$29bn has been entrusted
to private equity fund managers. PIFs or SWFS (discussed
in more detail elsewhere on this site), found in the US,
Europe and elsewhere, comprise pools of capital provided
by the sale of assets, mineral royalties and even tax
surpluses. Returns from investment may be allocated to
a specific use or used widely for public purposes, including
age/disability pensions for all eligible citizens.
The New Mexico Endowment (drawing on revenue from land
grants, mineral leases and state taxes) for example was
worth US$6.7bn in 1996. Norway (where the former Oljefondet
is now worth over US$241bn) and Brunei have invested revenue
from oil and gas production licenses in national funds,
looking ahead to the time when their petroleum resources
are exhausted. Some capital from those funds has in turn
be provided to private equity managers.
The sophistication of such funds - and more broadly the
activism of their trustees and managers - varies considerably.
Critics of smaller funds in the US have argued that they
are strongly risk averse, wary of community criticism,
less likely to invest a major portion of their portfolio
(the average in the US is 6% of the PIF/PPFs capital)
and that there may be conflicts between managers and trustees,
supposedly because managers are concerned about reputation
and remuneration whereas trustees are likely to be political
appointments with agendas at variance to maximisation
of capital growth.
Some criticisms are misplaced. CalPERS for example, along
with peer TIA-CREF, has gained recognition for emphasising
corporate governance and improved performance rather than
being captured by the executives and boards of the enterprises
in which it invests. In Australia the major government
superannuation funds operate on a wholly commercial basis.
As with other participants, constraints vary by jurisdiction.
In the many PPFs are restricted from collectively comprising
more than 10% of the capital of a single fund and investment
is accordingly biased towards the larger funds, PPFs tend
to invest in larger partnerships.
Insurers
Participation by general and specialist insurers reflects
their cash flow (eg premiums by the insured), inhouse
expertise and expectations about outsourcing some funds
to specialists, historic performance by their own staff/advisers
and formal or tacit restrictions by regulators.
Some insurance groups have traditionally been active,
even entrepreneurial, in asset trading and investment
partnerships. On occasion that has involved innovative
approaches to mezzanine financing and trading derivatives.
Others have been highly risk averse or restricted to a
narrow class of assets such as blue chip (gilt) shares,
bonds and prime real estate.
Extended horizons mean that many have invested in property,
some of which is currently being transferred to PE funds
(for example MetLife's US$5.4bn sale of property in New
York in 2006).
Global trends to deregulation, accompanied by poor performance
of some traditional investments, has encouraged insurers
to expand from one-off deals with affiliates to substantial
participation in private equity partnerships and creation
of PE management entities (eg Prudential's Catalyst Investment
Managers). That participation is typically under 5% of
an insurer's portfolio but because of the size of capital
at their disposal is a major contributor to the private
equity fund industry at all levels.
Banks
Blurring of traditional demarcations is evident in participation
by banks, including those with a focus on consumer lending
and merchant (aka investment) banks. Those financial institutions
are taking stakes in private equity funds and hedge funds,
attracted by perceived higher yields than mainstream lending.
Some are also acting as private equity fund managers or
spinning off units as independent PE managers. Permira
thus originated as a unit of what was the Schroder banking
group.
In the US 1930s era restrictions on banks have fundamentally
eroded. The 1956 Bank Holding Company Act authorised bank
holding companies to invest in the equity of companies
as long as that stake does not exceed 5% of the outstanding
votes and 25% of the total equity. (The 1958 Small Business
Act authorises banks to own and operate 'Small Business
Investment Corporations', aka SBICs). The 1999 Gramm-Leach-Bliley
Act enables banks to engage in merchant banking activities
through a financial holding company (FHC), with a ceiling
of ten years for direct investments and 15 years for investment
in private equity funds.
US banks have avoided direct investment in favour of PE
funds, given -
- diversification
(a fund typically has stakes in several companies)
- appearances
(the bank is not seen to be running the company) and
- perceived
costs (the manager rather than the fund participant
is responsible for supervising the acquisition).
It
is important to note cultural differences: German banks
have for example taken and retained substantial direct
stakes in major enterprises over the past 50 years.
Individuals
and families
The tradition of private banking, centred on services
to individuals and families with substantial assets, means
that those people were prominent in early development
of private equity. Their significance has declined, with
institutional investors such as insurance companies and
pension funds providing an increasingly large share of
capital used by private equity managers (particularly
the larger PE funds that deploy US$1 billion or more).
It has been suggested that families are more comfortable
with cross-border PE investment (given an interest in
asset diversification) and a greater willingness than
managers in some institutions to wait on returns in the
medium term, therefore preferring private equity over
hedge funds.
It appears that families typically make commitments of
between US$1 million and US$5 million, roughly a quarter
of participation by institutional investors, although
some high net worth individual and families are reported
to have put US$100 million or more into particular funds
and groups of funds.
It is important to note that personal expectations and
cultural factors are important: risk aversion, expertise
and reliance on managers varies from country to country.
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