Asset Classes

Thematic investing in public markets is often biased towards small-caps with emerging business models or technologies. But Joseph Mariathasan finds that the process does not translate smoothly into private equity

The days of private equity success through financial leverage and arbitraging P/E ratios with the listed markets are now long gone. It is clear that the future mantra for success in private equity is going to be adding value by operational improvements. As a result, private equity firms need to have clear sector expertise which, in many cases, can mean that they focus on particular themes. The obvious example is the venture field, where many of the leading high-tech private equity firms such as Kleiner Perkins or Sequoia have a reputation, built up over decades, for being able to utilise their own expertise in technology sub-sectors to enhance those of the firms they acquire. But venture, both in the US and Europe, is now very much a niche area for private equity investors, since there have been many instances of mediocre or dismal performance. For most investors, the question that is more relevant is whether thematic investing has a part to play outside the specialist high-tech sectors associated historically with venture.

While the idea of industry specialists within private equity firms using their expertise to leverage the operational activities of the firms they invest in sounds very attractive, a focus on specific themes does need to be treated with care as it can also have its drawbacks. Cleantech, for example, is a sub-theme that is currently very much in fashion: There were 75 new cleantech private equity funds at a conference I went to last week, notes Simon Faure, a director of Prudential Portfolio Managers. It is interesting that LPs prefer the future promise of a new theme to investing in an existing sector that they already have experience of. If you look at venture capital, a huge amount of funds have been raised for clean tech — which is surprising because it has been very difficult to raise any money for venture capital and most people raising money have no track record.

But there are dangers in launching a fund exclusively focused on what might be a narrow theme. We are quite concerned that if you raise a fund for such a niche, you end up putting investments into it because you have to, worries Colin Wimsett, CIO of Pantheon. Bruno Raschl, CEO of Adveq, goes even further: I’m not sure clean tech is a real investment theme, he says. I used to think that in the early 1980s and 1990s. But today, European governments could improve everyone’s lives by making companies live to ESG principles. We would not need a separate category for clean tech investing, as everyone would be doing it.

Another fundamental problem with many themes is that their life may be short when, as Sam Robinson, a director at SVG Advisers, points out, the typical investment period for a private equity fund may be five years. As a result, we cannot define a theme and if, for example, health clubs are a great idea, we expect our managers to find that out, Robinson explains.

It is clear that many mid-market buyout firms do have specific skills which are reflected in the type of investments they make. In general, private equity firms have specialisations in three or four sectors, and the bulk of our money is with firms that have this multi-sector expertise, says Tycho Sneyers, partner at LGT Capital Partners. They cannot be too narrowly focused as there would not always be enough dealflow. In such firms investors are much more reliant on management skill than in any overall industry beta to generate their returns.

But for a theme to be attractive enough to launch a focused private equity fund around that could benefit from a general market revaluation, it has to have certain key characteristics. The most obvious one is size, as this enables the firm to explore a large universe of possible investments without being forced to make an investment in a sub-standard opportunity because of a lack of choice.

In addition, as Faure points out, different parts of a large sector would move at different speeds within a business cycle, giving investors the ability to smooth out some of the inevitable fluctuations of the cycles in each sub-sector.

The second characteristic is longevity. Private equity funds are typically invested over a period of five years and it might be 10 years or more before all the investments are sold. The sector has to be sufficiently long lived for there to be the opportunity to realise attractive valuations many years into the future. An obvious such sector is healthcare and as Patrick Reeve, CEO of Albion points out: Healthcare is sufficiently large and as there is always a requirement, it will never go out of fashion, even if certain sub-sectors are expensive for a while.

Another sector is infrastructure, which Wimsett sees as a product extension for private equity firms. Environmental/clean tech, it can be argued, also fulfil both criteria, but may be more controversial for the reason that Raschle outlined — there is not a clearly definable universe that can be separated out.

Infrastructure is an interesting theme from the private equity viewpoint. Many of the earliest public-private partnerships undertaken by the UK government during the 1990s, such as the privatisation of the rolling stock companies that owned the UK’s trains, were immensely successful for private equity firms such as Candova and Nomura.

The successes, many would argue, also reflected a fundamental mis-assessment of the risks and hence the pricing by most of the marketplace and, in today’s world, Wimsett argues that such deals would be seen as too expensive for private equity investors and such infrastructure opportunities are perceived as a separate asset class.

The 25 years-plus timescale of infrastructure investment certainly can make it difficult to position within a private equity framework that relies on an alignment of interests between LPs, GPs and the management of the companies.

As Wimsett points out, GPs and management need to see wealth creation over a period closer to 10 years for them to be motivated and 25 years is certainly too long. But for Pantheon infrastructure investment can be split into two components. The first is the core assets that generate cash for ever, but yield a low return, albeit at low risk and these are ideal for pension funds. The second is the value creation that occurs during the early years of infrastructure projects and there are a number of value creation’ managers that raise 12-year funds, explains Wimsett. For such investments, there could be a realisation or a valuation event after 10 years, enabling some investors to realise their investments and management to realise their carried interest, but Wimsett admits that the industry is still grappling with the details.

The biggest driver of change in the global economy is of course the rise of emerging markets. As well as encompassing major themes such as infrastructure and healthcare, it offers the tantalising prospect of specific new ideas that also satisfy the two core requirements. One good example of this is microfinance, which has achieved much prominence with the award of the 2006 Nobel Peace prize to Muhammad Yunus, the founder of Grameen Bank, one of the pathfinders in developing microfinance as a profitable way of alleviating poverty.

Microfinance has now become an accepted and valuable component of emerging market development, with many local firms set up throughout the globe to develop initiatives. But these are not just social initiatives, they are also profitable economic activities in their own right, although very much coming under the theme of socially responsible investment. Blue Orchard MicroFinance Investment Advisers, for example, is a specialist private equity firm headed by Jean-Philippe de Schrevel that has raised $165m from a core group of six institutional investors — including $75m from APG — to invest in microfinance initiatives in emerging markets. The dealflow arises through the connections that its sister company, Blue Orchard Finance (also founded by de Schrevel) has developed over the past 10 years when it provided debt finance for 156 Microfinance Institutions in 40 countries.

According to de Schrevel, the objective is to: provide mostly straight equity with some subordinated convertible debt when necessary; allocated across the globe; have a carefully crafted mix of microfinance; take significant minority shareholder stakes with board seat in most instances; and exit when attractive opportunities arise — which would be essentially trade sales and IPOs.

Despite the social as well as the economic objectives of the strategy, Blue Orchard is still targeting a healthy net IRR of 20% to investors and his current investor base, although small in numbers, has deep pockets. An example of a typical investment is a 10% stake it has taken in Asmitha, a leading regulated non-bank finance company in India, where it was the first external investor invited by the promoter. It has very high efficiency and solid profitability with exponential growth and a presence in 13 Indian states, with over one million clients already. The market potential is still huge and it is clearly on its way to an IPO, explains de Schrevel.

It is clear that themes in developed world such as healthcare, infrastructure and perhaps even environmental/clean tech funds are attracting investor interest, while in emerging markets, they have additional new possibilities such as microfinance. But deciding what may be a narrow fad and what represents a genuine long-term sustainable market opportunity might be the key issue that investors should be addressing.