“Price is what you pay, value is what you get”
(Warren Buffett via Benjamin Graham)
All investors, whether in public or private markets, are seeking value. In other words, they want to invest in something that will be more profitable tomorrow than it is today (on a risk-adjusted basis).
However, how value is created may differ depending on your investment strategy. When you (or a fund manager) invests in companies listed on an exchange, the way value is derived likely differs from that of a person or fund manager investing in private markets.
In this instalment, we explore how private equity fund managers create value for investors and how investing with them may differ to investing in listed markets.
The one about the two economists
You’ve heard the joke about two economists walking down the street. The first economist sees a $5 note and says to the other "Look, a $5 note has been left on the ground." The second responds, "There can't really be a $5 note. If there was, someone would have picked it up already!”
While it is easy to take a dig at economists, what the second economist is really saying to the first is, “there are no opportunities for obtaining abnormal returns because, if there was, it would have already been discovered and exploited” (it is an ‘efficient market’).
The humour derives from the second economist’s dogmatic belief that, despite the evidence of the first, there could not be value lying around.
However, we should not be so quick to dismiss the insight of the second economist completely out of hand. An inquiring mind might want to know more about what the first economist saw, how far away was the note? How good are the economist’s eyes? How busy was the street? It is not hard to see how the circumstances might change to change the second economist from fool to philosopher.
When it comes to investing, what is the likelihood that the world looks more like that of the first economist or the second? Just with the economists, an inquiring mind might want to know more about the environment or characteristics of where you are investing.
With billions of dollars in market depth, thousands of analysts poring over company announcements, and hundreds of algorithms trading to the nanosecond, public markets are under intense scrutiny. It is not just that it is a crowded space, but it is crowded specifically with people trying to find that $5 note lying around. In other words, in markets with great depth and information flow, the ability to find value that is not already priced in is going to be more difficult. There is likely little daylight between the value and the price. This is not to say you cannot, we are not in a world of absolutism, it is just going to be more difficult.
When you, or a private equity fund manager, makes an investment in this market, the subtle bet they are making (whether they appreciate it or not) is that they believe they have been able to identify a difference between the true value of the company and actual price of the shares. A discrepancy everyone else, all who are equally looking, has missed. Are they right? Maybe. Is it likely? It depends, there are just not that many $5 notes lying on the floor of the ASX.
Private investment strategies… how do they differ?
While private equity and real assets managers also want to “buy low and sell high”, and equally are competing for value, they are not so dependent on the broader market coming to the party to agree on value. Instead, private equity and real assets managers are able to create value by (metaphorically) getting their hands dirty and directly influencing the strategy and operations of a company or asset to improve its financial performance. In other words, rather than hoping to find a $5 note on the ground, they are actively working to create the value in the first place.
In order to do that, a private equity and real assets manager undertakes a detailed due diligence process before purchasing a company or asset. Their aim for this process is to identify areas within the company that the manager believes could be made more efficient and effective. These improvements will then in turn, improve the financial performance of the company or asset. For example, for a private real estate fund manager it can be as simple as acquiring a building with a high level of vacancies and leasing them up.
To be able to gain this high level of influence the private equity and real assets manager will typically take a controlling interest (usually above 50% of the company’s equity) to enable it to execute the strategic initiatives and enhancements it identified in the due diligence process. In contrast, a listed assets manager will often have a stake in a company amounting to less than 1% of a company’s total shares, making it difficult to influence the strategy and operations of a company.
In the sections below we provide specific examples of how private equity and real assets managers may create value.
Case study – private equity value creation
A leading private equity manager purchased a software-as-a-service platform providing payments management software in 2019. The private equity manager identified the following areas of value creation:
- Upgrade management team, resulting in a good mix of legacy open source knowledge and innovation leaders – supported by a high-calibre board;
- Expansion of emerging products with the highly strategic Company X acquisition as well as continued organic investments;
- Geographic expansion into underrepresented regions such as North America; and
- Execute financial planning and analysis project in order to increase reporting and financial transparency, pathing the way for product portfolio optimisation initiatives.
The manager successfully executed those initiatives and over a three-year period improved sales by almost 40%, and its profit margin increased by approximately 15% (increasing from 42% to 48%). This resulted in a gross multiple on invested capital of 1.9x.
Case study – real assets value creation
A leading private infrastructure manager purchased a US provider of data centre infrastructure in late 2020. The private infrastructure manager identified the following areas of value creation:
- Utilise strong local presence of manager to establish and accelerate growth in Europe;
- Leverage existing customer relationships and manager network to grow in new markets;
- Execute on strategic merger and acquisition (M&A) opportunities and extract synergies given the fragmented nature of the data centre market; and
- Continue to innovate and reduce capital expenditure.
The manager continues to work on those initiatives but over 18 months sales have increased by almost 30%, while its profit margin has remained static. To date that investment has generated a gross multiple on invested capital of 1.3x.
It would be wrong to leave this instalment and believe that one type of investment is better than another, and should be used to the exclusion of the other.
Beyond the difference in value creation, there are characteristics about private market investing that can present challenges for investors. Investments in private markets are typically illiquid, meaning it is not easy to get your money in and out, and have capital calls, meaning the amount you want to invest is not invested all at once and may be called over a number of years.
We think there are some real benefits from having some exposure to private markets, given the differential driver of value. However, whether and how much will be something each investor needs to consider for themselves or with the help of their financial adviser.
For more information about our available private equity funds, please visit our private equity funds page.
