DR.CHENJIAZI ZHONG

The growing interest in private equity investments has arisen among the institutional investors in the U.S., particularly endowments and foundations. The most significant reason of which include: compared to public equities, private equity has the potential to earn superior long-term returns, partly because private equity investors can accept an additional element of risk due to the illiquidity nature of private equity investments. More importantly, from the portfolio perspective of an endowment, private equity provides a source of diversification that can reduce overall portfolio risk, primarily due to the fact that private equity focuses on a longer-term investment opportunities so it is relatively insulated from short-term valuation fluctuations that are associated with the public securities markets. During the 2008-2009 global financial crisis, many large endowments altered their private equity strategy by reducing their allocation and future commitments, but as a matter of fact, they have never stopped seeking investment opportunities in the asset class.

Since 2012, private equity has been poised to capitalize on debt markets, as a result of the resurgence of IPOs and M&A activities. As of September 2013, the year-to-date IPO deals were 153, and over 200 companies were expected to debut by the end of the year, which were the highest in IPO market since 2007.

According to the press release of October 7^th 2013 by Thomson Reuters and the National Venture Capital Association (NVCA), during the third quarter of 2013, 26 venture-backed IPOs raised $2.7 billion, a 13 percent increase from the second quarter of the year and an 11 percent increase in dollar terms compared to the previous quarter.

In the M&A markets, 107 venture-backed M&A deals were reported for the third quarter of 2013, 31 of which had an aggregate deal value of $4.9 billion, the strongest quarter by disclose deal value since the third quarter of 2012. The average disclosed deal value was $157.4 million, a 21 percent decrease compared to the second quarter of 2013.

In the U.S., continued confidence in economic recovery, rising equity markets has been another catalyst for private equity investing. Some private equity firms are taking advantage of the Small Business Administration (SBA) programs to leverage their funds with cheaper debt, some are being very innovative and entrepreneurial with the approaches to realize gains, without charging LPs higher fees. Another emerging phenomenon in the U.S. is that more and more private equity firms are working with hedge funds in order to seek investments within the alternative assets space.

Despite the volatility in the private equity markets, outside the U.S., emerging markets and pioneer markets have had generated strong returns since 2012. Among BRIC countries, Brazil realized the most solid returns. Other areas, including Africa and Latin America in general, also performed very well.

The Yale Endowment is widely recognized for its investment philosophy in this space. The Endowment’s private equity portfolio, overseen by Timothy R. Sullian, who joined the Yale Investments Office in 1986, had a target allocation of 35.0 percent as of fiscal year 2012, far exceeded the 10.9 percent actual allocation of the average educational institution for the same period.

There are a few things for investors to consider:

• Private equity firms, in particular related to LBOs, are facing more legal scrutiny, as the Internal Revenue Service (IRS) adopted a new “acquisition technique.” Additionally, there may be higher tax rates to be paid by buyout executives on profits that they earn from the current 15% tax rate. The potential less-profitable deal flow available also threatens the profits of PE firms.
• More recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) amended a provision of the Investment Adviser Act of 1940 that had previously provided most private equity firms with an exemption from the SEC registration. Dodd-Frank eliminated the broad 15-client exemption, and as a result, most private equity firms now must register with the SEC if the private equity investment manager has more than $110 million in assets under management. Besides the new registration requirement, the SEC has recently announced that they will likely step up their oversight and actions against private equity firms over the next few years.
• In terms of the investment activities in the emerging markets, the relatively weak legal systems at the local countries may limit deal flow by limiting the number of people with whom a private equity manager can do business, as historically only under an efficient legal system could “strangers” collaborate and make transactions. Moreover, some private equity managers expressed that management talent may be missing in many companies in the emerging markets. Furthermore, in Latin America, for instance, there is almost no leverage, so private equity firms have to focus on operating capabilities. However, despite a variety of challenges, I think investment opportunities in the emerging markets, especially Asia, will continue to grow. The Chinese government, for example, is highly interested in getting capital to its small businesses, which experienced private equity managers can definitely help.
• I went to the “Responsible Investment Forum 2013” held in London on June 13, 2013, where I learned that there is a continued push by private equity investors worldwide for lower fees and revised fee structures. This is another important factor for both private equity firms and investors to consider because eventually, this may impact private equity managers’ incentives to source ideal investment opportunities.

These considerations, however, do not discount the critical role that private equity investments play in a portfolio and the overall capital markets, particularly for institutional investors such as endowments and foundations who have a longer-term horizon.

References:

1. Press Release by Thomson Reuters and the National Venture Capital Association on Oct 7^th, 2013 
2. Private Equity Global Report 2013 by Bain & Company
3. “United States: Under The Looking Glass: SEC Targets Newly Registered Private Equity Fund Managers in Annual Investment Advisor Compliance Examination Process” September 12, 2013
4. “IRS Scrutinizes Certain Corporate Buyouts Involving Debt” by Fortune Finance August 2013