When the skill of the fund manager is not always what it seems…..
Friday, 16 January 2009
There is something special about say a private equity firm that can spot how they can improve the performance of a company by bringing their expertise to perhaps introduce new management or any other such operational improvements. Forgive my analogy, but it’s a little like Sir Alex Ferguson spotting a young Cristiano Ronaldo and through management skills allow the players talent to flourish to become the best player in the world.
Yet management skills in private equity may not be in as much abundance as perhaps one would have expected. In fact, the news suggests that some of the biggest private equity firms were simply using debt to fund performance rather than operational talent.
The findings were published on Wednesday 14th in the first annual report on the performance of private equity portfolio companies, compiled by the British Private Equity and Venture Capital Association and Ernst & Young and reported in the FT on January 15th.
Here is how it works. Debt has a multiplying effect on returns. If a company is bought with £100m of equity and sold for £200m, the investor doubles their money. But if the same deal is done with £20m of equity and £80m of debt, the investor makes a sixfold return.
The FT looked at some of the biggest deals “The aggregate investment return on 14 of the biggest deals realised in 2005-2007, including Debenhams and NCP, was 3.3 times, or 330 per cent of the return achieved by the FTSE All-Share in the same industry sectors and timeframes.
Of this 330 per cent return, 100 percentage points came from rising stock markets, 167 points came from the use of extra debt over the amount at comparable companies in the same sector, and 62 points from “strategic and operational improvements”.
So what you may say? Well, the 100 point rise in the stock market had nothing to do with the private equity firm. In effect that was available to anyone. There was 167 points from adding gearing. How many homeowners use mortgages to fund property and have become asset rich in doing so! Yet, it can go the other way. If asset prices can fall, gearing can wipe you out. As such, will investors have been aware of he risks of the gearing in private equity?
The 62 points from expertise is something I like to see and therefore the due diligence on behalf of investors is to establish the likelihood of the managers consistently applying those skills to optimise the return year on year.
This brings me back to Madoff…so many investors failed to carry out due diligence before investing. They were focused more on what they could make without understanding where the returns came from. This principle applies to every single investment you make. Whether it is a single share, an investment trust, unit trust, hedge fund or similar, the message is why am I buying this investment and have I carried out adequate due diligence to ensure I am aware of the risks.
The stock market is a wonderful place to allocate your capital, but it is also has its dangers that due diligence can minimise or mitigate.
posted by Murray Round Wealth Management @ 17:02,
The Authors
Nicholas Round
Nic is the Managing Director of Murray Round Wealth Management Limited, who seeks to ensure the advice provided is truly independent. Based in Shropshire with clients local, national and worldwide, Nic has strived to find the best possible service for his clients needs, by researching and studying the market, trends and philosophies. Nic strongly believes Asset Class Management will bring his clients Financial Freedom, Independence and Happiness.
Kirsty
Kirsty is our communication guru. Managing information requires considerable due diligence and her passion for organisation gives the clarity we all seek. From Shropshire, with a Psychology Degree and much travelling, she is now back in Shrewsbury...and London often, keeping us all at Murray Round focused.
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