Speculators in small stocks hunt for fabled “tenbaggers” that soar tenfold in price. But the real killing is made from unlisted companies that deliver returns of 100 to 200 times.
Speech and text-recognition star Appen is an example. Private-equity firm Anacacia Capital and Appen management invested in it in a 2009 capital raising at less than 10¢ a share. Appen listed on the ASX in 2015 at 50¢ and trades above $23.
Such returns are fantasy for most investors. For every Appen, hundreds of start-ups destroy capital, and the best opportunities usually go to institutional investors, wealthy families, sophisticated investors, other entrepreneurs and those in the know.
Growth in private equity is a response to rising regulation, governance and shareholder activism.
— David Beatty, a McKinsey senior adviser
Also, small investors have few opportunities to invest in funds that back local and international unlisted companies. Private-capital funds are often closed to retail investors or require large commitments, even though the case for a modest portfolio allocation to the equity and debt of privately-owned companies is strengthening.
Moves are afoot to connect small investors with opportunities in private capital – an umbrella term for venture capital, private equity and private credit – via the ASX. And to treat private capital like an asset class in model portfolios for retail investors.“Investor demand for private capital is growing quickly,” says Yasser El-Ansary, CEO of the Australian Investment Council (AIC). “There is a significant shift under way globally as more capital is allocated to private equity, venture and private credit opportunities.
“Many in the private-capital industry are looking at how products can be put together that provide opportunities for retail investors to participate in this asset class. I expect to see many private-capital products launched in the next few years.”
Boom in offerings
Pengana Capital Group in April closed a $100 million to $600 million initial public offering (IPO) for a listed investment trust (LIT) that invests in global and Australian private equity funds. The Pengana Private Equity Trust will be the first of its kind on the ASX and among the few vehicles that take a fund-of-funds approach to private equity and is open to small investors.
Partners Group, a Switzerland-based investor with $US83 billion ($117 billion) in assets under management, is launching a $500-million LIT on the ASX this year that will invest in private debt opportunities.
That will follow ASX listings of Metric’s MCP Master Income Trust and Neuberger Berman’s NB Global Corporate Income Trust. These and other funds invest in the bonds of global companies, some of which may be unlisted.
Private equity is booming overseas. US private equity investment rose 8 per cent to $US331 billion in 2018, American Investment Council research shows. That has doubled since 2010 as giant US pension funds increase their allocation to alternative investments. Globally, private capital assets under management exceed $US5 trillion, notes McKinsey.
Behind this growth are technology “unicorns” – start-ups that achieve a $US1 billion valuation – remaining privately owned for longer. Transport disrupter Uber, for example, was founded in 2009 and will list this year through an IPO valuing it above $US100 billion.
Rival ride-hailing firm Lyft had an IPO in March and is worth $US20 billion. Online scrap-booking site Pinterest is due to list in the US with an expected $US11 billion capitalisation. In years past, high-growth firms listed on stock exchanges much earlier to raise capital.
David Beatty, a McKinsey senior adviser and director of public and private companies, believes growth in private equity is a response to rising regulation, governance and shareholder activism.
“The costs of going public and listing on exchanges are starting to outweigh the benefits for some firms,” he says. “Founders are keeping their company privately owned for longer because they don’t want to spend 20 per cent of their time dealing with a board or investors. They don’t want to be hamstrung by quarterly reporting or have to deal with rampant shareholder activism.”
The Toronto-based Beatty says the private-equity boom has a long way to run. “You don’t need to list a good company on an exchange these days to raise capital because there’s a lot more of it available in the private sector. The result will be fewer listed companies and investors looking for higher returns from private equity.”
Long-term trends support Beatty’s view. The number of US-listed companies has halved since 1996, according to the University of Chicago. British listings have halved since the late 1990s.
Although listing volumes have fallen, their aggregate value has increased as companies have grown through mergers and acquisitions. Still, IPO volumes for US companies capitalised above $US50 million have more than halved since the 1999 peak, suggesting fewer opportunities to invest in high-growth emerging listed firms.
By contrast, ASX listing volumes have remained steady for a decade and the combined market capitalisation is up by a third since 2009, to almost $2 trillion. The ASX is attracting offshore companies that are too small for US markets and suit this market.
The confluence of these trends suggests fewer listed companies globally, much larger companies in the private sector, potentially higher returns from privately-owned companies that are not bogged down by listing rules and regulations, and more capital chasing this outperformance.
That should drive steady growth in Australian private capital, albeit off a relatively low base. Assets under management by private equity and venture capital firms were almost $26 billion at December 2017, from $15 billion in 2007, shows AIC data.
Like their overseas peers, local private-capital funds are outperforming. The Australian Private Equity and Venture Capital index returned 11.2 per cent annually over 10 years to September 30, 2018, AIC data shows. The S&P Small Ordinaries index delivered 4.8 per cent.
As investors struggle with lower returns from shares and cash, private capital’s outperformance appeals. But Australian investors have been slow to increase their exposure to private capital assets compared to overseas funds.
The average allocation of local industry superannuation funds in private capital is thought to be about 4 per cent, of which half is invested overseas. Giant US pension funds allocate 10 to 15 per cent and Australia’s Future Fund, a consistent outperformer, has 15 per cent in private capital, although it has different investment objectives to super funds.
This low allocation is due to two factors. Private-capital funds have higher fees because they involve more active management compared to funds that invest in listed equities. Also, the large scale of Australian super funds makes it harder to invest in small- and mid-market fundraisings from private capital firms.
AIC’s El-Ansary expects a gradual increase in superannuation allocations to private capital. “These allocations will increase because funds need to access the returns that are consistently generated through private capital. Many talk about the Future Fund’s 15 per cent allocation to private capital as an aspirational target for other funds, but even if the target was just 10 per cent, it will likely take a few years to get there.”
El-Ansary says domestic private-capital funds under management could double to $50 billion in 10 years, which is still modest in the context of Australia’s $2.6 trillion retirement savings pool.
“The number of promising private companies in Australia seeking equity or debt capital funding is rising every day. And the amount of capital that is becoming available from our industry for those businesses is expanding. It’s a matter of joining the dots," he adds.
How to get in
Therein lies the problem. Australia’s private capital industry has not done enough to educate investors about private-capital investment. In fairness, top-performing private equity funds have had few problems raising institutional capital, meaning retail investors were largely unrequired. But that is changing as the $726 billion self-managed superannuation fund (SMSF) sector seeks private-capital opportunities.
New opportunities are needed. Retail products in Australian private capital remain fragmented and opaque. They range from company founders tapping their networks to raise funds to angel investors, equity crowd-funding platforms, venture capital funds that accept capital from those who qualify as “sophisticated investors”, some private-equity funds and a grab-bag of listed investment companies or unit trusts that specialise in private capital.
Some of these channels involve investing directly in unlisted companies, a risky strategy.
“Investing in a portfolio of private companies is difficult for retail or private investors to achieve without using a fund,” says Jeremy Samuel, managing director of Anacacia and a former Appen director. “Each business can be highly risky, so to have a concentrated investment in one or two unlisted companies is not particularly wise unless it’s a business that you know well.”
Equity crowd-funding, which enables large numbers of retail investors to invest online in private companies, was the big hope after the federal government enabled this form of capital raising in 2017. For all the hype, equity crowd-funding has collectively underwhelmed, with some platforms changing their business model, unable to connect companies and investors.
Pengana CEO Russel Pillemer believes the Pengana Private Equity Trust will fill a gap for retail, high-net-worth and SMSF investors. Managed by Grosvenor Capital Management, a US private capital investor, the trust provides exposure to global private equity and has a small allocation to credit funds.
“We designed the trust for financial advisers and direct clients who want to build a private capital allocation in their model portfolios,” says Pillemer. “Until now, it hasn’t been possible for direct investors to get exposure to global private equity funds. The best funds are mostly only available to institutions and are mostly closed to new investors.
"Those that accept new money often require a starting investment of $10 million and for it be held for at least 10 years. Or there are other complications such as a small part of committed funds being drawn down and the rest required to be provided as new investments are made.”
The Pengana trust will provide exposure to more than 600 unlisted companies as it grows. The focus is mostly mid-market, unlisted US companies with a valuation of $1 billion to $2 billion and the trust will invest through a fund-of-funds and co-investment approach.
“Our research suggests there is a sweet spot in mid-market private equity funds,” says Pillemer. “A lot of US companies of this size find it’s not worth listing on US exchanges and prefer to remain private.”
He says retail investors may have misconceptions about private equity. “There’s a perception that investing in unlisted companies means taking big bets on tiny companies. They may not realise you can invest in hundreds of private companies with billion-dollar valuations, worldwide, through a fund approach.”
Pillemer says the LIT structure solves a problem with private equity investing: liquidity. Investors buy and sell units in the trust via the ASX, similar to a real estate investment trust. The trust does not need to fund redemptions by holding cash or selling assets.
Pillemer says the use of the Pengana trust in model portfolios constructed by financial advisers will aid its liquidity. “As funds flow into model portfolios, more of that will be allocated to private capital over time, which should provide a natural source of liquidity for the trust.”
However, investors have been sceptical of private equity listed investments companies (LICs) and trusts. They fear the illiquidity of the underlying asset class will cause the LIC or LIT to trade at a large discount to its net asset value. Also, LICs and LITs have a lower profile on the ASX and some struggle to attract buying and selling, creating layers of illiquidity.
For example, Bailador Technology Investments, an investor in unlisted growth-stage tech companies, has assembled a strong portfolio yet trades at a big discount to its pre-tax net tangible assets.
Another risk is the introduction of market beta (a measure of volatility) to private equity trusts. Although private equity assets have a lower correlation with sharemarkets – a key selling point – wrapping the asset into a listed structure potentially introduces sharemarket risk. Simply, if the sharemarket tumbles, private equity LICs or LITs may fall with it.
Moreover, many LIC IPOs from the past three years are trading below their issue price. Even prominent asset managers that have entered the LIC market have struggled to gain traction, prompting claims of LIC fatigue among investors and managers cashing in on LIC hype.
Also, there have been alternative-asset disasters on the ASX, notably Blue Sky Alternative Investments, which was attacked last year by hedge funds for its fund valuation, business model and treatment of off-balance-sheet assets.
Other private-capital funds have struggled to attract investors. An Evans Dixon Group fund that provides venture capital exposure reportedly fell short of its targeted investment last year. And the Pengana Private Equity Trust is expected to secure the lower end of its $100 million to 600 million raising. Early market speculation suggested the trust could raise up to $1 billion.
Partners Group’s Australian operation is among the few private equity managers that have attracted significant retail investment. About $15 billion has been raised in Australia for its funds since 2009, of which $1.5 billion is retail. The firm has three open-ended funds that retail investors, mostly through independent financial advisers, can invest in alongside institutions.
Martin Scott, head of the group’s Australian operation, says private debt can provide attractive returns. “We’re seeing more interest in private debt as banks restrict lending and as investors search for higher yield,” says Scott. The term “private debt” typically refers to debt that is not financed by banks or traded in an open market. Instead, private debt funds provide credit to listed or unlisted companies.
Partners Group’s upcoming private debt fund is expected to invest in the debt of up to 150 companies, many of them with billion-dollar values, in developed markets. The private-capital giant is the world’s largest private equity and debt firm in mid-market companies and tracks more than 10,000 of them worldwide.
At the smaller end of private capital is Steve Torso, managing director of Wholesale Investor, a fast-growing platform that connects sophisticated investors with capital-seeking private companies. He says interest in this form of investing is booming. Wholesale Investor’s network has more than doubled to 21,500 investors in three years and offshore numbers are building.
“We are getting a lot of interest from investors in China, Singapore and London and are starting to build inroads into India,” says Torso. “Foreign investors see potential in unlisted Australian companies, particularly in healthcare, life sciences and information technology. They realise that a lot more of the action these days is in the unlisted space.”
These investors may be hoping to spot the next Appen and achieve lottery-like gains. But tech “unicorns” are called that for a reason: they are so rare as to be almost mystical. And even Appen, winning plaudits for its gains as a listed company, took a decade to take off – a time frame that is beyond most speculators who hunt for the next big thing.
By Tony Featherstone - Tony writes on Personal Finance specialising in Superannuation & SMSFs, Specialist Investments. Email Tony at firstname.lastname@example.org
18 April 2019