Media Article: Demystifying private equity

April 7, 2017
The Financial Standard

This opinion piece was published in The Financial Standard on 18 April 2017. Although the private equity (PE) industry in Australia is now almost thirty years old, to some people it remains shrouded in mystery. What is the business model of PE? What are the intentions of PE when they approach a company? Who are their investors?Overseas, the PE industry has come to be seen as a mainstream part of the national economies, filling a market gap for companies in need of both capital and expertise, rather than debt. For example, in the UK and the US, PE deals over FY2012 to FY2016 accounted for an average of 22% and 25% of all M&A deals respectively. This was in contrast to Australia where PE accounted for just 7% over the equivalent period.We also know the money invested by institutional investors in PE is substantially less than that invested overseas. Latest data shows US public pension funds invest 9.2 percent of their portfolio in PE, while for Australian superannuation funds that number is closer to 5 percent.All of this means the industry must continue to work harder to explain its role in the economy, strengthen its ties to the broader business community, and debunk some persistent myths. Creating an ongoing dialogue with institutional investors is crucial to the long-term growth of the PE industry in Australia.What role does private equity play in the economy?The industry has come a long way since 1987 when Bill Ferris, now chair of Innovation & Science Australia, and Joseph Skryzynski formed AMIL, the first Australian PE fund.Today, there are around fifty active PE fund managers in Australia, with approximately $24bn under management. In total, PE funds count 375 investee companies in their portfolios, across almost all sectors of the economy, including health, retail, energy, and technology.Contrary to popular myth, Australian PE has a strong record of job creation. Deloitte Access  Economics analysis shows that the average workforce for a PE -backed company grew from 378 to 1,636 FTE jobs over a five-year period, representing an annual compound growth rate of 27.6%.The same research shows that PE supports, directly and indirectly, around 500,000 jobs and contributes around 4 per cent to Australia’s annual GDP.What is the private equity fund model?Put simply, the business model involves PE fund managers providing both capital and expertise to add value to a portfolio of companies. These companies may be at different stages: from a business looking for capital to expand, to distressed businesses in need of a turnaround capability, or publicly-listed companies seeking a new direction.PE firms aim to deliver strong returns to investors within a typical ten-year fund timeframe, allowing adequate time to add value across a portfolio of companies, before exiting those investments and returning capital back to the investors.Although the large transactions make headlines, over financial years 2014 to 2016, the average PE investment was $38m, highlighting the fact that in Australia most PE transactions take place in the small and mid-market area of the economy.PE aims to build better businesses that are much more competitive and profitable into the future, long after PE has exited their original investment. This involves developing a long-term plan together with the management teams of each company to grow the business and increase its value in a sustainable way over the long-term.PE is able to achieve results through a combination of operational improvements, access to networks and new markets, and high-quality management teams. The strategy may also include restructuring the investee company’s board of directors and strengthening corporate governance practices.Unlike other forms of investment, the investment of PE equity capital and operational value-add takes place over a number of years, with an average five to seven-year holding period, and a strategy focused on intrinsic value creation. When the time is right for PE investors to sell down their shareholding, it’s common for a range of divestment options to be considered, including the option of selling the holding to a strategic buyer, or perhaps a public equities market listing through an initial public offering, or a secondary sale onto another PE investor who can continue to work with the business for the next phase of its growth plan.Who invests in private equity funds?Investors in PE funds are predominantly institutional level providers of capital, including super funds, overseas pension funds, sovereign wealth funds and funds of funds. Australia’s sovereign wealth fund – the Future Fund – has around 10% of its capital base invested into PE domestically and internationally, while a range of Australia’s best-performing super funds have meaningful allocations ranging from 2% to 5% of their capital base.There is significant scope for a greater number of institutional investors to allocate capital into PE, which would help to fuel of growth of investment into great Australian businesses that can expand and create tens of thousands of new jobs across the economy every year.The Australia Private Equity & Venture Capital Index, prepared by AVCAL in conjunction with international research house Cambridge Associates, shows the PE industry has consistently out-performed listed markets, producing 12.1% net of fee annual returns over a 15 year timeframe, 9.76% over ten years, 15.06% over five years and 19.93% over three years.When you compare the consistent and attractive long-terms returns that can be generated for superannuation and pension fund members through a well constructed PE investment strategy, it paints a very compelling picture of why future allocations of capital into PE in Australia should accelerate into the future.