At the beginning of July, when most pension fund and asset managers were focusing on their forthcoming holiday excursions, Sweden’s financial supervisory authority – Finansinspektionen – was concentrating on more pressing and complex matters: the rising debt levels of private equity and venture capital firms.

The supervisory body hit out that private equity companies enjoyed too much freedom and not enough regulation and that transparency needed to be “improved with regards to how private equity houses run their businesses”, in particular their levels of debt.

At the same time, Sven-Erik Österberg, the Swedish minister for local government and financial markets, warned that he may have to introduce a new law to force private equity and venture capital firms to disclose information about their borrowing. “I am ready to give Finansinspektionen a clearer mandate in order for them to scrutinise the activities of venture capital companies,” he said. His concerns centred around the fact that almost SKr30bn of AP fund money is tucked away in private equity funds.

Seven layers of debt

The unprecedented growth in debt levels is rooted in the recent benign economic environment and historically low levels of interest rates, explains Luba Nikulina, a senior investment consultant at Watson Wyatt.

“Debt structures have become more complex with up to seven layers of debt of different seniority in one package. Non-traditional lenders, such as hedge funds, have helped to increase debt market liquidity, keep interest rates low and soften lending standards, while default rates have reached an all-time minimum. In this loose credit environment, the probability of some leveraged buyouts going sour is high.”

But the results of nrpn’s latest quarterly survey, which took in 11 pension and insurance funds with some €85bn of assets under management (see pages 14), show that investors in Sweden and the rest of the Nordic region do not fully share these concerns.

The survey found that five of the 11 respondents intend to increase their exposure to private equity over the next six months, six plan to keep their holdings at the same level and not one intends to reduce its allocation.

“We invest approximately 1.5 per cent of our portfolio in private equity,” Eeva Grannenfelt, chief investment officer at the €5.32bn Pension Fennia, told nrpn. “And, while our exposure to the asset class is still minor, we believe that an increasing allocation to private equity will be a common trend in the future.”

Reasons for expansion

Expansion will take place for various reasons, adds Ms Grannenfelt: “Mostly because not all investors want to invest in the stock exchange and because private equity has a number of structural advantages that listed equities do not”.

Hannu Hokka, managing director of the €920m VR pension fund, which covers the employees of the Finnish state railways, agrees: “We started investing in private equity approximately a year ago and ever since we have been expanding our activities to include a multi-branch buyout investment. Today we have almost 2 per cent of our holdings in private equity. It is a good asset class for long-term investors with decent return opportunities.”

Our latest quarterly investment survey did, however, find that Nordic pension and insurance funds are not completely at ease with the asset class. Three respondents said that they were concerned about the level of pricing in the market (see below), two said that they were most worried about risk and four had doubts about market transparency. Interestingly, two investors were most alarmed by a lack of good managers and advice.

“We have always invested about 2 per cent of our portfolio in private equity and will continue to do so in the foreseeable future,” says Jussi Laitinen, CIO of Ilmarinen, the €21.8bn Finnish mutual pension insurance company. “But in the current market environment, increasing your allocation to private equity is challenging. There is enormous interest in the asset class, which enables managers to charge high fees. It is complicated to hire the best managers because there is so much interest in the sector. In this environment, as the markets are heating up and most investors are changing their approach to private equity, investors are in a relatively weak negotiating position.”

Sam Robinson, a director at SVG Advisers, a fund of funds private equity house, sympathises with Mr Laitinen. “The asset class is opaque, there are few people with real experience, and the industry is gaining in popularity,” he says. “That makes managers expensive and hard to find, so I would not recommend a pension fund trying to recruit one directly unless it has significant capital and can keep the manager happy.”

Unsurprisingly, he puts forward a fund of funds approach as a more suitable alternative. “A better route is through a fund of funds manager who puts together a diversified portfolio of the better managers. Yes, they charge a fee - usually about 1 per cent - but for that you get experience and more chance of investing in the best managers, which can easily make a 1,000 basis points difference to returns each year.”

A further worry for funds is whether or not the sector, which has churned out returns of up to 40 per cent over the last five years, can continue to maintain such a stellar performance.

“We are not concerned about transparency or a lack of decent managers but we are worried about future returns from the asset class,” says Timo Löyttyniemi, managing director of the €8.3bn Finnish state pension fund.

The basic law of economics says that abnormal returns attract abnormal inflows of capital, adds Ms Nikulina at Watson Wyatt. “Investors often take a rear mirror view on returns and push money into the most popular asset classes. More capital means more competition and lower returns, and this is what is happening now in private equity. Spectacular performance of large buyouts has attracted the attention of institutional capital. Private equity fundraising is hitting historical records and the mean reversion of returns is unavoidable. Whether this is going to be a smooth slowdown or a sharp fall, we need to wait and see.”

SVG’s Mr Robinson agrees: “PE has produced exceptional returns over the last five years, which you cannot assume will continue. But when I say exceptional I mean 30 to 40 per cent and higher net of all fees, and across many managers. The historic long-term goal for the better managers has been more like 20 per cent and, although I am sure this will fall, I expect it to be 17 to 18 per cent. Assume 15 per cent for prudence – but that is still double what most people expect for quoted companies.”

The trick, it would seem, is distinguishing the good managers from the bad. Getting that wrong could set you back up to 50 per cent a year suggests Mikan van Zanten, a partner at Robeco Private Equity.

Ms Nikulina sums up her house view: “There are clear signs that private equity as an asset class has attracted too much attention and may become a victim of its own success but pension funds should not stay away from the sector – they instead need to exercise discipline in investing and diligence in selecting managers.

“It is important not to rush but to ensure reasonable diversification across managers with different investment styles and funds of different vintage years. The asset class provides a different type of exposure and helps to enhance returns through additional premiums, such as illiquidity, activism and information asymmetry. There is a place for private equity in institutional investors’ portfolios.”

INVESTORS SHARE NEED FOR GREATER TRANSPARENCY

According to the results of nrpn’s latest quarterly investor survey, which took in 11 pension and insurance funds with some €85bn of assets under management, Nordic institutional investors agree with Finansinspektionen, the Swedish financial supervisory authority, that greater transparency is needed among private equity and venture capital companies.

The results found that more than a third (four) of respondents find a lack of transparency most concerning about the private equity market while two investors said that they were most concerned about risk.

The findings come after Sven-Erik Österberg, the Swedish Minister for local government and financial markets, announced that he may introduce a new law to compel private equity and venture capital companies to disclose information about their borrowing. His concerns centred around the rising levels of indebtedness among private equity and venture capital firms and the risks this posed to pension investors.

The survey also found that two investors are most concerned about a lack of good managers and advice within the private equity field while three respondents are most worried about price. Not one investor was concerned by liquidity.

“In the current market environment increasing your allocation to private equity is challenging,” Jussi Laitinen, CIO of Ilmarinen, the €21.8bn Finnish mutual pension insurance company, told nrpn. “There is an enormous interest in the asset class, which enables managers to charge high fees. It is complicated to hire the best managers in the field because there is so much interest in private equity. In this environment, as the markets are heating up and as most investors are changing their approach to private equity, investors are in a relatively weak bargaining position.”

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SLEEPING GIANT STARTS TO STIR AND DRAG ITS HEELS ON PRIVATE EQUITY

Pension liabilities are impacting private equity deals, and are becoming more influential during bid negotiations, says a new survey from Mercer Human Resource Consulting, Marsh and Kroll. The survey of 100 leading private equity firms in Europe found that almost a fifth of respondents (19 per cent) had pulled out of a deal because the target company had an under-funded pension scheme.

The survey found that four in 10 respondents (40 per cent) now mitigate against the risk of under-funded pension schemes by adjusting the price of the deal, while 21 per cent use warranties and indemnities.

Eric Warner, worldwide partner at Mercer, says: "Like sleeping giants, pension liabilities have started to stir and make their mark on private equity deals. While large pension deficits will not always cause deals to collapse, they will often have a major role in price discussions. Like it or not, vendors have to accept that an under-funded scheme could have a great impact on the value of their business."

He added: "Pension liabilities can be a major stumbling block, so private equity firms should carry out robust due diligence to ensure they have the right information to embark on successful price negotiations."

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FRR, the French Pensions Reserve Fund, made its first moves into the private equity arena in December last year. While most pension funds and their managers were closing up shop for the festive period, the €28.1bn buffer fund launched its  €1.5bn private-equity search and put out tenders for four mandates: a €450m European brief, a €250m European small- and mid-cap mandate, a €450m North America diversified brief and an international diversified portfolio of secondary positions worth at least €150m.

The selection process is ongoing and is expected to be over by the end of this year but the first stage of FRR’s tendering programme was finished in June with some 20 private equity houses being taken through to the second stage of proceedings.

“We are aware of the difficulty for first time investors to deploy significant allocations in today’s tight market and that is why we decided to delegate management outside of FRR to funds of funds managers and to break the allocation down into several discretionary mandates,” the scheme told nrpn.

After two years of relative weakness in 2001 and 2002, it adds, “global private equity activity significantly increased from the beginning of 2004, both in terms of capital invested and capital recently raised by private equity groups. The economic environment in which private equity firms operate has also evolved, leading to an increase in transactions such as recapitalisations and secondary buy-out deals. The wait and see attitude of institutional investors, which had prevailed since 2001, has disappeared.”

The fund’s secondary positions will include US holdings but the allocation will be predominantly made up of European investments – a feature of FRR’s shift into private equity.

“Today, the private equity market is still biased towards North America, which presents two-thirds of all investments but the growing maturity of the European market gives European institutions the opportunity to build portfolios [locally],” says the fund.

FRR will allocate between 60 to 65 per cent of its private equity allocation to Europe with 30 per cent invested in the US. A remaining allocation of 5 per cent will be used for investments outside of the US and Europe, as and when opportunities arise.

Antoine de Salins, chairman of FRR’s manager selection committee, told nrpn’s sister publication, epn, in a recent interview: “To invest €1.5bn in the private equity market was a big decision for us, but we are not going to invest that money straight away – that would be foolish. The amount reflects the size of our fund and, by the end of 2006 when we will most probably take our first steps in the asset class, we will have some €30bn under management.

“In that respect €1.5bn is a suitable amount to invest. If we want to be serious in our efforts to diversify our holdings then we have to invest serious amounts of our assets.”

The investment horizon of the programme has been set at three to five years with a commitment phase to new private equity vehicles spread between 2006 and 2010 in order to diversify fund vintages, capture the best private equity funds and avoid putting excess pressure on managers to invest.

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