Removing the mystique
Written by Charlotte Moore
Charlotte Moore explains how the private equity industry is providing more transparency and dialogue with pension fund investors
Private equity: the very name projects an enigmatic aura. For years this industry has been shrouded in mystery, giving away little information about its own brand of financial alchemy to the wider world.
While it might be hard for those outside the investment community to gain access to the inner workings of a private equity fund, investors have always had access to information. But the quality of that information has improved in recent years.
Mercer director of private equity fund of funds Sanjay Mistry says: “The opacity of the industry has been a myth from our perspective because we’ve always had very good transparency and visibility on what is happening within a fund.”
It would be impossible for pension consultants to evaluate the private equity industry without detailed information so they place a very high value on a fund’s transparency.
Aon Hewitt senior consultant of infrastructure and private equity Hans Holmen says: “Part of our rating process is to comment on the transparency of private equity firms and we base this on how open they are with respect to reporting and information requests.”
While the consultants had a good dialogue with the private equity industry, the end investor - the pension funds - now request much more information from their private equity funds than they did in the past.
Mistry says: “Pension funds want more information from their asset managers, particularly in alternative asset space. The demand for more information was initially driven by pension schemes’ interest in the notoriously opaque hedge fund industry but has bled across other asset classes.”
Private equity funds have responded to those demands by increasing the amount of information that they provide to their investors and industry bodies have taken steps to provide industry guidelines.
Mistry says: “In the last two or three years, a number of private equity firms have come to market looking for new investors. They have had to address any information gaps and have made a lot of changes about they communicate.”
Holmen says: “The Institutional Limited Partners Association (ILPA), unveiled new principles in 2011 which include guidelines on transparency of reporting pertaining to fees, capital calls, distribution notices and other disclosures.”
In addition to this, private equity firms should also provide detailed information on performance of the fund and its portfolio companies, adds Holmen.
Morgan Stanley Alternative Investment Partners managing director Neil Harper says: “Today, investors spend more time and attention on the composition of their illiquid portfolios and are more focused on transparency and reporting. As a result, the larger private equity funds have responded by increasing staffing in their investor relations functions to better communicate with clients.”
Those communications will also include detailed commentary in each of the investments. Actis director of investor development Marc Nahum says: “Investors want to know not only how the investments are valued but also how the underlying investments are performing at the trading level.”
Investors demand more regular reporting than have done in the past. Nahum says: “Ten years ago, it was okay to report on only a semi-annual basis but investors now demand quarterly reporting.”
Part of this drive to improve the transparency of the industry has not only been driven by investor demand but also by changes in regulation. Holmen says: “The European AIMFM directive requires a certain level of transparency as well.”
PPM Managers investment director Simon Faure says: “The private equity industry now realises that it has to more stakeholders than just its sophisticated investors. It now realises that it needs to communicate with the customers of its investment companies as well as the press and the government.”
Some private equity funds have embraced these requirements for more information wholeheartedly and go above and beyond the information required. “While there is room for improvement at a few private equity firms, from what we have seen, transparency is generally at a good standard,” says Holmen.
It’s not only that pension funds have increased the amount of information they require from this industry, the type of information they require has also changed.
One of the most dramatic shifts has been an increasing demand for environment, social and governance (ESG) information.
Nahum says: “Five to 10 years ago, less than 10 per cent of our investors would be interested in the ESG impacts but today 30 per cent of investors really want to know how private equity investment is helping to improve not only shareholder profitability but other factors that affect the company’s other stakeholders.”
During the financial crisis, the private equity industry got a bad reputation. Nahum says: “The industry was perceived as being run by a small group of callous bankers who were only interested in leveraging a company to the hilt and then asset flipping.”
Today’s European pension funds want to ensure that there is a real creation of value that goes well beyond improving the financial performance and structure of the company, he adds.
The emphasis placed on ESG criteria varies according to geographical region. The ESG agenda has long been a key concern for both Nordic and Dutch pension funds but it is now gaining momentum in the UK and starting to see gain traction in Switzerland.
It’s not only that European pension funds are more demanding about matching ESG criteria from an ethical standpoint; this is also a good mechanism to ensure that the investors receive their return on the investment.
Faure says: “For a private equity firm to realise its returns, it has to be able to exit the business. That means it has to demonstrate to potential buyers that this is an asset worth owning with good long-term prospects. Meeting good ESG criteria helps to demonstrate these qualities.”
Investors not only require more information for individual private equity funds: that’s also the case for private equity fund of funds. Nahum says: “In the past, investors have only been interested in historic performance but they are now more interested in the projected future returns.”
Harper says: “We are seeing an increased appetite from investors for more focused PE exposure, whether it is smaller cap buyouts, special situations strategies, or to emerging markets, with interest across primaries, secondaries – that is pre-existing private equity investments - and co-investments.”
“When investing in secondaries, investors are concerned about a manager’s strategy and position in the market, and how that translates into deal flow and the discount to market value that can be achieved. They’re also focussed on asset quality and what is contributing, both positively and negatively, to performance and the overall health of the portfolio,” he adds.
Harper says: “Over time, the data available on the performance of fund of funds portfolios has become gradually more robust, allowing investors to be much more selective.”
While existing private equity investors may have access to all the necessary information, the industry will have to find a way to communicate more clearly with potential new investors.
Mistry says: “The reality is that the traditional investors in this asset class, like pension funds, are not increasing their allocation and the industry needs to expand its investor base.”
That provides a challenge for private equity funds to communicate more clearly about their funds while still managing to keep the details about their investments and their strategy private.
Faure says: “Let’s not forget that other private companies are under no compunction to share information, so why should a private equity owned company have to reveal potentially sensitive financial information?”
The environment today is very different to the one before the financial crisis. For sophisticated investors, such as pension funds, private equity firms are working hard to provide the information that this investors require. As the industry widens its investor circle, that trend is set to continue.
Charlotte Moore is a freelance journalist