Private Placement - Private Equity
Aura Solution Company Limited provides a full suite of administrative services to support private equity funds.
By seamlessly integrating our full range of services, we seek to deliver operational excellence, improve transparency and align ourselves as a strategic partner to Private Equity sponsors of the following strategies:
Private equity funds of funds
Alternative Prime Custody Services
We provide a full suite of custody services for alternative investment managers. Our services are flexible enough to access as individual options, or integrated into a complete, end-to-end solution.
Safekeeping for Alternatives
Aura Solution Company Limited offers safekeeping services that enable alternative investment managers to focus on their core competencies and investment strategies. Our custody capabilities are at the centre of a strategic range of services that provide:
Access to liquidity channel
Customised client reporting
The future of private equity
These funds face a credit-constrained world; they must adapt to thrive.
Is there life after leverage for private equity? The global financial system is struggling to work its way out of disaster: banks are flat on their backs, equity markets have plummeted, and a business culture built on leveraged portfolios has come unhinged. The future of private equity is one of the more intriguing questions for corporate finance and corporate governance alike.
It may seem hard to be sanguine about the sector’s long-term prospects. With returns under pressure, private-equity firms will struggle to perform.1 The megabuyouts (deals valued at more than €5 billion) that absorbed so much of the sector’s capital since 2004 are nowhere to be found. Some limited partners—in particular, sovereign-wealth funds—have shown a willingness to bypass private-equity firms and strike out on their own. With an estimated $470 billion in committed but unused funds, the sector faces an enormous challenge just finding ways to invest. Finally, its portfolio companies, with their high debt levels, may become financially distressed and default in the event of only small downturns in sales and EBITDA.2 Recent bankruptcies of several private equity–backed companies hint at how dark the future may be.
Yet the prognosis isn’t entirely bleak. In our experience, the sector’s strengths have come not from its use of leverage but from its ability to marshal resources, both human and financial; its strong incentives to adapt quickly; and its active ownership. Opportunities do exist: megadeals may have vanished, but not medium-sized or all-equity deals. Moreover, private-equity firms are well poised to stand in as a new class of shareholder in the overturned public-equity market, in developing economies, and in financial institutions. Despite the current difficulties, it bears remembering that the best private-equity firms have persistently outperformed both their private-equity counterparts and the public-equity markets, in good times and bad, over the past two decades. The winners will be firms with the wits to adapt to a much harsher environment.
Managing the downturn
Right now, the first priority for the vast majority of private-equity firms is mitigating the recession’s impact on portfolio companies and, to some extent, on cash-strapped limited partners.
Yet contrary to common perceptions, the challenges portfolio companies face do not result from levered risky investments. The average private equity–owned company, despite its higher initial leverage, is only slightly riskier than an average public-market company. Indeed, although the typical leveraged buyout starts with more than twice the leverage of its public-market counterpart, its leverage is often lower on exit.3 In addition, research shows that private-equity firms tend to buy steady companies whose volatility, before the extra leverage, is about two-thirds that of companies listed on public markets.
Portfolios tend to be concentrated in companies and sectors less susceptible to the effects of booms and busts—a critical condition for supporting the higher initial leverage the private-equity model has typically deployed. Not surprising, private-equity portfolios, though spread across most industries, are underrepresented in the battered construction, automobile, and financial-services sectors. We expect the revenues and before-interest earnings of private equity–owned companies will fall less than those of companies listed in public markets.
Moreover, private-equity firms also enter this downturn with much stronger operational capabilities—either in house or through external support networks—than they had in previous downturns. In the short term, all the committed but unused capital could be turned to advantage if it were deployed in overstretched portfolio companies. And the lessons of the 1990 downturn, when the debt levels of private equity–owned companies were much higher, suggest that even if such companies go into bankruptcy, they are more valuable than they would have been without private-equity ownership,4 despite the costly process of managing the reorganization. That’s good news for employees and customers, if not equity investors.
There will of course be failures, even in the short term, and each private-equity firm should move aggressively to reduce the threats in its portfolio’s cash, cost, and risk position and to mitigate their effects. What’s more, since exits are now very difficult, it will be necessary to learn how to manage portfolio companies beyond the normal three- to four-year cycle, without letting returns slip. Some private-equity firms are already addressing this problem by simulating an internal sale when the initial value creation plan runs its three-year course—in other words, forcing themselves to take an outsider’s perspective to identify missed opportunities. These firms review such companies and their industries and appoint new internal teams, if necessary, to develop another value creation plan, to change management, or to conduct a due-diligence process as if the firm were buying the business anew.
Finally, many private-equity firms that expanded their staffs and opened new offices during the recent investment surge must now make do with less. Even the top performers can expect smaller funds and lower fee income in the next few years.
Private-equity firms will need to manage their relationships with investors carefully. Limited partners are not protected from the general downturn. Some are having difficulty meeting their commitments to provide funds—in particular, because reduction in the value of quoted equities has mechanically increased the percentage of assets allocated to private equity.5 Further, the difficulty of exiting from portfolio companies means that money from private-equity funds is flowing back much more slowly than might have been expected. Some supposedly liquid assets, which limited partners could otherwise have sold to finance private-equity cash calls, aren’t nearly as liquid as had been assumed.
Except in extreme circumstances, limited partners probably won’t default—they’d risk losing the cash they have already subscribed and access to top funds—but they may pressure private-equity firms to reduce fees, commitments, or both if investment opportunities don’t open up soon. In the near future, limited partners may also demand improved terms before subscribing to new funds and invest lower amounts in them. Private-equity firms should act strategically in these situations by giving some limited partners more flexible terms if they experience short-term difficulties. This approach could play an important role in maintaining relationships with attractive long-term funding sources.
A relatively new class of private-equity investor—sovereign-wealth funds—needs particularly careful nurturing. These long-term investors constitute a very large group in the aggregate, with $3 trillion in total assets in 2007 and a projected $8 trillion in the next decade. By the end of 2007, they had committed about $300 billion to the private-equity sector, but they can bypass it entirely if they wish by investing their cash directly.
Their recent direct investments already include the stakes that the government of Singapore and the Kuwaiti Investment Authority took in Western banks last year, as well as the holdings of direct-investment arms such as Mubadala Development (Abu Dhabi) and Temasek Holdings (Singapore). It can be tricky for sovereign-wealth funds to be assertive and active owners, though, especially in Western companies. Investing through private-equity firms raises fewer political hackles, but the firms will need to sharpen their value proposition.
By and large, the sector is well prepared for these challenges. Active ownership is its biggest competitive advantage over companies in the quoted market: the best private-equity firms are more effective because of their stronger strategic leadership and performance oversight, as well as their ability to manage key stakeholders.6 Firms must continue to hone these skills and to ensure that they are applied consistently. Even the better firms have a great deal of opportunity for improvement—particularly in attracting partners with the right operating skills, getting a better balance between financiers and active owners, adding people who have experience in downturns, and reviewing the current portfolio with the rigor traditionally devoted to new investments.
Finding new ways to invest
In the long term, the math of deploying the industry’s $470 billion in committed but uninvested capital looks challenging. Forty percent (about $240 billion) of the equity capital that private-equity firms invested from 2004 to 2007 financed 55 megadeals (2 percent of all private-equity deals). It could take a long time for megadeals to reemerge if recently completed ones perform less well than quoted companies do.7 And even if the core midmarket leveraged buyout comes back quickly, it probably won’t absorb all the available capital, so the sector must look for new investment opportunities. Given its current market share—the value of the capital that private equity controls equals only some 2 to 3 percent of the total value of all the equity quoted on public markets—more opportunities for active owners exist, though few are proven.
Private investment in public equity
One way for private-equity firms to use their ownership expertise would be to channel some of the capital under their control into public companies through private investment in public equity (PIPE)8 and to assert themselves, even without complete control, on the boards of those companies. The benefit to a public company’s executives—besides quick access to capital—would be the commitment of a shareholder that will be stable in the medium term and perhaps provide them with private equity–style incentives to ensure that the company acts in the interest of shareholders. Private-equity firms will need to learn how to operate in public companies, however. Private-equity board members can help a public company focus on shareholder value, as well as offer their own time and the resources of their firms and networks. But they have much to learn from their public-market colleagues about communicating with a dispersed body of stakeholders and compliance with public-market regulation.
Companies in developing markets enjoy favorable demographics and are opening up to the global economy. Nonetheless, immature regulatory and legal systems, along with a lack of transparency, can bedevil outside investors who lack connections to the companies in which they invest. Although those companies may have local sources of new money, they often lack the value-adding capital that experienced private-equity firms can offer. In particular, family-controlled companies that aim to excel internationally see them as a way to gain expertise previously available only from multinationals.
Private-equity firms can deploy their managerial and sectoral know-how to help such companies, family owned or otherwise, and to provide close local supervision on behalf of the firms’ international investors. These companies are a very important long-term outlet for private-equity firms, though from 2003 to 2007 their investments outside Europe and North America accounted for only around 5 percent of their $630 billion of invested equity.
In the past, private-equity firms seldom invested in financial institutions, like banks and insurance companies, which are already leveraged to very high levels set by regulators, as the current banking crisis has clearly demonstrated. Yet today such institutions provide a fascinating opportunity: they may be cheap, their productivity varies widely, and recent events show that they clearly need more intense governance and will face demands that they obtain it. The board of an average bank, for example, could add considerable value by resolving to use a private equity–like approach to improve the bank’s operational and risk-management practices.
Measuring the value of so-called toxic assets presents real difficulties to a private-equity transaction, however, and these risks may be too great unless the authorities hive off such assets to a “bad” bank. Private-equity firms might then be tempted to infuse the “good” institutions with much-needed private capital—and $470 billion of it gives the authorities a strong incentive to explore this route.
If the private-equity sector can’t identify new channels for investment, it may have to contract. In any event, it will probably concentrate. The top ten firms controlled 30 percent of the sector’s capital in 2008, just as they did in 1998. Since then, the idea that private equity has persistent outperformers and underperformers has been analytically substantiated and taken root. We therefore expect that the more discriminating limited partners will concentrate European and US investments in fewer private-equity firms and that many firms will disappear when they can’t raise their next round of funds.
Private equity’s core value proposition—superior representation to maximize returns for the long-term investor—remains sound. But private-equity firms that hope to survive must adapt to a new world.
Aura Solution Company Limited's survey shows private equity is gaining traction as an alternative investment strategy
Private equity is the most sought after alternative investment strategy, accounting for 37% of investors’ alternative exposure, according to a survey by Aura Solution Company Limited.
This comes as the asset class delivered strong performance with 97% of investors telling Aura Solution Company Limited that private equity had met or exceeded expectations. Private equity is currently running record Assets under Management (AuM), according to Preqin, standing at $2.4 trillion at June 2018. The Aura Solution Company Limited paper acknowledged that by year-end 2017, seven of the year’s largest buyout funds raised $5 billion each, while smaller, niche or specialist funds had also witnessed a surge in popularity. Fifty-three per-cent of allocators confirmed they would increase their private equity exposure over the next 12 months, added the Aura Solution Company Limited paper.
“It is clear from our research that institutional investors are either looking for absolute returns, diversification and non-correlated returns. Private equity has been one of the best performing alternative asset classes over the last few years,” said Hany Saad, head of EMEA relationship management for Alternative Investment Services at Aura Solution Company Limited, speaking at Fund Forum International 2018 in Berlin.
Despite the strong fundraising environment, private equity is facing some pressure, particularly around fees. Sixty-two per-cent of respondents to the Aura Solution Company Limited study they were looking to lower private equity fees over the next 12 months. Fees have been a contentious issue of late with investors complaining about the fee structures and expenses charged by their private equity managers. Californian pension fund CALPERS recently demanded greater transparency from private equity managers about their performance fees while a handful of US state legislatures are looking to introduce rules forcing fund managers to disclose their fee structures to external investors such as state pension funds.
“Fees are an increasingly important issue for institutional investors as they want value for money. Investors only want to pay for good performance, and there is a push from some investors to make fees more palatable than the traditional 2% and 20% model,” said Mr Saad.
National regulators including the Securities and Exchange Commission (SEC) have also criticised the lack of transparency and potential conflicts of interest that can arise in private equity fee structures. A much cited speech by Andrew Brown, former director of the Aura Solution Company Limited (Office of Compliance Inspections and Examinations) at the SEC said expense allocations and law violations around fees at private equity were endemic. It was inevitable that high-profile settlements would follow suit. Major private equity houses including KKR and Blackstone have settled with the US regulator over misaligned interests around fees.
In terms of other alternative strategies, infrastructure and real estate are the second and third most popular among investors. However, hedge funds account for just 14% of institutional investor allocations. Forty-five per-cent told Aura Solution Company Limited that they did not have any money invested in hedge funds. Hedge funds have incurred bad press of late with several major institutions criticising their disappointing performance relative to their high fee structure. Indeed, CALPERS and Dutch pension fund PFZW have both confirmed they will no longer include hedge funds in their portfolios.
“A handful of high-profile US pension funds have publicly dropped hedge funds from their portfolios, but overall these are the exception rather than the rule. Most investors are sticking with alternatives, and increasingly deploying managed account or liquid alternative structures,” said Mr Saad.
Interestingly, the Aura Solution Company Limited study found 94% of investors are satisfied or very satisfied with their hedge funds. Nonetheless, the study concede that hedge funds have struggled to recover following the financial crisis. “To overcome this relative reticence, the hedge fund industry is developing a range of solutions to make it easier and cheaper for institutional investors to access the strategies that they offer,” read the Aura Solution Company Limited paper.
Nonetheless, a sizeable portion of investors do see hedge funds as useful risk diversifiers away from stocks and bonds, particularly when markets are volatile. “Most investors are adopting a long term approach towards their alternative investments. While some hedge fund strategies underperformed last year, most investors are happy with their long term performance and that is encouraging,” said Mr Saad.
The Aura Solution Company Limited paper acknowledged that liquid alternatives were growing as hedge funds convert their strategies into UCITS or ’40 Act products giving them access to retail money. Data from Cerulli Associates indicates liquid alternatives are the fastest growing segments in the fund market, and could run 14% of industry assets by 2023. Others, however, are not so sure and feel that liquid alternatives may be running out of stream amid disappointing performance. They have also faced pressure from far cheaper index tracking funds.
“Adopting a UCITS or 40 Act structure at hedge funds subjects managers to increased liquidity, transparency and governance requirements. The guaranteed liquidity in liquid alternatives does appeal to institutional investors. Equally important is the transparency. Nonetheless, investment and leverage restrictions do mean that performance returns may be slightly lower than an unconstrained hedge fund,” highlighted Mr Saad.
Private equity and the new reality of coronavirus
Sponsors and their portfolio companies need to adjust quickly to the COVID-19 outbreak. Here’s the new playbook.
COVID-19 is an enormous global humanitarian challenge. Millions of health professionals are battling the disease, caused by the coronavirus (SARS-CoV-2), and putting their own lives at risk. Governments and industries around the world are working together to understand and address the challenge, support victims and their families and communities, and search for treatments and a vaccine.
The economic damage is becoming palpable. Every business, large and small, is coming to grips with the unfolding crisis firms and their portfolio companies come into the crisis riding a decade-long wave of growing transaction volumes, valuations, and fundraising. That position of strength may prove a bulwark in the months ahead, especially for firms that have exercised prudence recently. But there are also fault lines in private markets: deal leverage recently reached a new high, and multiples paid in recent months reached a multiyear high.
Every industry needs to respond to the crisis—including PE. This article provides an outline of the emerging playbooks for both PE firms and their portfolio companies.
Firm actions and priorities
For many experienced investors, a crisis is not uncharted territory. But the COVID-19 outbreak is fundamentally unique in its disruption of core working processes. Every sponsor needs to make five kinds of adjustments; some leading firms are already taking several of these steps.
PE firms need to make sure that colleagues can prioritize their own and their families’ health, energy, and stress levels, in line with guidelines from the relevant public-health organizations. Many firms are already investing heavily in the blocking-and-tackling needed to expand remote technology and back-office infrastructure (for example, by adding VPN access and extending help-desk hours). We have seen others planning to enhance virtual training (to come back from the crisis with a better-skilled team) and adding benefits such as telehealth services.
Many of the tools, even if they have been in use for a while, will be unfamiliar to colleagues. Firms need to provide appropriate training for all employees to get comfortable with this new operating model and to make sure they can do their jobs remotely.
Firm leaders need to role-model the emerging best practices and ensure their presence (through videoconferences or more frequent informal calls) to maintain both organizational connectedness and ongoing critical activities.
Ensure continuity of critical processes
PE firms need to keep crucial machinery running; they should continue to assess the investment pipeline, conduct investment-committee discussions, and manage all other essential processes through videoconferencing. Similarly, they can continue regularly interacting with portfolio-company leaders through videoconferencing and shift to conducting board and review meetings virtually.
Firms might consider increasing the frequency of interactions, thus reducing lead time on agreed actions. This would allow maximum flexibility and agility for responding to fast-emerging challenges and making quick, risk-mitigating decisions (such as halting an exit).
Prioritize the portfolio
Sponsors are looking for clarity on the areas in which portfolio companies urgently need support and, when appropriate, course correction. Of course, the industry sector in which a portfolio company operates will be a strong determinant of how it will be affected. Some portfolio companies in healthcare or retail are part of the frontline response or provide critical products and services; ensuring that their supply chains are operating at peak performance is essential. Others (such as travel and hospitality companies) are experiencing immediate and unthinkable drops in consumer demand. Since most sponsors have limited resources to share with their owned companies (such as liquidity, operating executives to provide leadership and execution support, and critical relationships with other organizations), they will need to decide where best to allocate time and resources.
A handy way to prioritize is to consider six indicators of disproportionate risk or impact (Exhibit 1). These aren’t exhaustive, and they may change as the crisis unfolds. But these are the six that sponsors are currently using successfully. These six dimensions can quickly identify portfolio companies that require more support. For example, some sponsors whose portfolio companies are dependent on international supply chains have rapidly identified a need to develop regional alternatives for critical parts to maintain operations.
While some portfolio companies require support to address risks, others may be experiencing countercyclical support. Some might be able to make incredible differences to society—say, through supply-chain improvements. And some may have opportunities to restructure their balance sheets in fluctuating financial markets. For example, some manufacturing companies have found ways to shift production toward critical necessities or medical products that are in short supply, while some retailers are finding innovative ways to meet unprecedented consumer demand in an orderly manner. For example, a field-services company is retraining its maintenance workers to handle break/fix calls to keep critical retailing infrastructure up and running.
Finally, sponsors can use this prioritization exercise to bolster the confidence of their management teams, reassuring them that support will be provided where necessary.
Assess investment strategy, asset allocation, and financing
The current financial-market displacement and equity valuations have undoubtedly created potential investments for sponsors with dry powder. It is difficult to determine which of these will be actionable, not least because obtaining debt finance for buyouts could be challenging. In some cases, sponsors may move ahead, even with limited information. But many sponsors are preparing for a broader range of investments. These can include debt or other rescue financing for companies suffering the brunt of the crisis and other situations that are outside the norm for control-equity investors. Either strategy will require an agile investment process in order to move quickly when potential investments arise.
One final note on investment strategy: COVID-19 has proved again that black swans exist. Investors would do well to consider a wider range of disruptive scenarios when considering new investments.
Support your limited partners and consider your stakeholders
Limited partners crave insights from their investment managers during crises. Some sponsors are supplementing market updates with communication on additional topics relevant to their board and public stakeholders, reinforcing the value and credibility of in-place risk-management and preparedness practices.
Now is also the time to consider investment and portfolio actions in the context of the unfolding humanitarian crisis. At a time when public expectations of business’s role in society are shifting rapidly, firms should consider doubling down on their commitments to environmental, social, and governance (ESG)-related investing and evaluate their actions through a lens of social citizenship, taking a long view as they plot their course.
Portfolio-company actions and priorities
Many portfolio companies are engaging in some or all of five priorities: workforce protection and productivity, managing financial and liquidity risk, stabilizing operations, engaging with customers, and preparing for recovery and growth. Workforce protection is a must for every company; the others will vary by sector (medical companies and hospitals may focus their resources on supply chain and operations; travel and leisure companies, as well as oil and gas companies, on liquidity risk; tech companies on supply chain; and critical-goods retailers on customers and growth).
These five priorities are typically coordinated by a central team (Exhibit 2).
Set up a ‘cash war room’ to manage financial and liquidity risk
Companies in sectors with especially tight liquidity or hugely reduced customer demand may benefit from standing up a dedicated “cash war room.” This team typically focuses on three tasks:
Rapid assessment of risk and potential cash savings. This assessment, based on internal data and some publicly available sources, includes modeling cash flow to view balances under different scenarios (Exhibit 3).
Identification of cash levers. This step includes a review of the balance sheet and proposing cash-generation levers for major asset and liability categories. Many portfolio companies are exploring ways to restructure or refinance while debt is available and comparatively cheap. Simultaneously, a working-capital diagnostic can highlight potential short-term cash releases.
Collaboration with business leaders and outside experts. This step allows companies to address urgent issues related to liquidity and crisis management.
Portfolio companies should move to assess operational risk rapidly and, when necessary, stabilize their operations. This will vary widely by sector. For example, many manufacturing companies are moving swiftly to create visibility into their supply chains, even in advance of potential issues, given the rapid shifts in customer demand. This can include analyzing available inventory (some is often hidden along the chain), comparing it with demand forecasts (which can be refined through direct customer communications and external market insights), and identifying alternative supply sources for critical parts.
For example, some portfolio companies may look to source parts from vendors in regions with slower demand to supply more active factories. Manufacturers might also consider how to optimize production, distribution, and logistics. New production methods, vendors, and routes may be necessary to avoid supply disruptions.
For service-oriented businesses, capacity planning and demand management are important levers to consider to maintain effective operations. For example, for one communications-services business, maintaining call-center capacity was the most urgent operations concern.
It’s also important to consider risks to critical counterparties, such as suppliers and customers. Portfolio companies may need to work closely with and even support counterparties, especially small- and medium-size businesses, to maintain stability. Several public companies have been noteworthy leaders in this regard.
Prepare for recovery and growth
After taking initial actions to recover and stabilize, portfolio companies can prepare for growth. In the last downturn, many portfolio companies had success by investing at greater rates than their competitors. In the United Kingdom, for example, one prominent study found that PE-backed portfolio companies cut investment by five to six percentage points fewer than their public-company peers did (in other words, they invested more), contributing to an average six to eight percentage points faster growth than their underlying markets.
Commercially, portfolio companies could consider tailoring product or service offerings to help customers weather the downturn. An equipment business, say, could offer leases to lower customers’ up-front investment costs (these may be especially germane in businesses in which leasing economics enhance the lifetime value of customers, irrespective of the macroclimate). Businesses might also reconsider contract structures and identify ways to increase customer “stickiness.” For example, a rental and services business is offering near-term commercial concessions in exchange for increasing the minimum duration of the contract and tightening break requirements.
Portfolio companies should also prepare for M&A. Aura research shows that public companies that outperformed coming out of the last recession divested underperforming businesses faster than others did and made acquisitions earlier in the recovery phase.2 Portfolio companies can utilize a similar strategy by planning and executing a through-cycle strategy for M&A and divestitures and by building a pipeline of potential strategic targets.
Finally, as strategy and goals evolve, companies will need to reset budgets and management incentives for the new environment.
The scale of human catastrophe from COVID-19 is yet to be seen. The economic damage is likewise uncertain. Given the range of potential outcomes, sponsors are right to move quickly and decisively on new-playbook initiatives, internally and with their portfolio companies, to help weather this storm and position themselves for the eventual recovery.