Unlocking private equity

A growing number of structured products have been launched that are designed to give institutional, high-net-worth and even retail investors access to private equity. Anuszka Mogford looks at some of the products on offer

Private equity has quickly become a key component in many investors' portfolios. Keen to diversify their investments, pension funds have been upping their allocations to private equity as an alternative asset class, while the industry's strong performance in the current merger and acquisition boom has caught the attention of a variety of other investors, both institutional and high-net-worth.

The problem is access. Hefty minimum investments, combined with the limited capacity of top private equity funds, means only large institutional investors are typically able to access the asset class. Then there's the issue of liquidity. Once a commitment is made, the cash is not necessarily invested immediately - the money could end up sitting in a deposit account for months until a suitable investment opportunity is found. Once it is invested, the investor is unlikely to achieve any return until the private equity firm sells out of the asset - perhaps three to five years down the line.

This means that, despite the attractive returns, the asset class has typically been closed to a wide swathe of investors. That is, until now. A variety of structured products has sprung up in recent months, aimed at giving institutional, high-net-worth and even retail investors easy access to private equity. Key to this development has been the emergence of private equity indexes, which have been designed to give broad exposure to the asset class.

One such index has been developed by Societe Generale Corporate and Investment Banking (SG CIB) in conjunction with Dow Jones Indexes. Called Privex, the index tracks the performance of the 25 largest and most liquid listed private equity companies, such as 3i Group, American Capital Strategies and Allied Capital Corporation, covering Asia, Europe and the US. The index is weighted by market capitalisation, although the weighting of any single company is restricted to 15% to ensure there is sufficient diversification between the index constituents.

Dow Jones is responsible for the selection of the index components, the index calculation, the ongoing maintenance and the index dissemination. The composition of Privex is reassessed every six months by Dow Jones, while the capping factors for the individual index members are adjusted on a quarterly basis.

"SG CIB's structuring desk began to receive various requests from institutional clients to structure products based on private equity funds," explains Frank Benzimra, director, structured products at SG CIB in Paris. "We looked at the secondary market but it was not deep or liquid enough to hedge a position, so we looked at alternatives, such as listed funds, and at the particulars of certain companies. This led us to consider creating an index to reflect this investment universe."

ABN Amro has also created its own indexes, as well as niche products linked to private equity. The bank has two indexes - the LPX Major Markets TR Index and the ABN Amro Private Equity Index. Both are similar, except for the fact the ABN Amro Private Equity Index references the shares of 16 private equity companies, while the LPX Index references 25 stocks.

"The indexes are very simple - in essence, shares listed on stock exchanges.The main aim is to give investors a highly diversified product," says Paul Thind, executive director at ABN Amro, based in London and Zurich. "The indexes are either equally weighted or have a maximum weight capped and then market capitalisation weighted, and are monitored daily with a base currency. All dividends are reinvested into the index."

Also active in this burgeoning asset class is Standard and Poor's (S&P), which launched its own private equity index in March. The S&P Listed Private Equity Index comprises the 25 leading listed private equity companies that meet certain size, liquidity and private equity-related criteria. Structures eligible for the index may take the form of publicly listed investment companies, business development companies, investment trusts, special-purpose acquisition vehicles, buyout funds and private equity funds of funds. Approximately 70% of the index comprises buyout firms, with the remaining represented by venture capital firms.

By focusing on the universe of listed private equity firms, these indexes arguably miss out on a huge segment of unlisted firms. However, Srikant Dash, an index strategist at S&P in New York and the designer and creator of S&P's Listed Private Equity Index, says increasing numbers of private equity firms have listed on stock exchanges in the past few years to meet investor requirements for liquidity and transparency, and as a source of permanent capital. He adds that the index is not meant as a replacement for private equity fund investing by large institutional investors and is instead more suited to smaller investors.

"Investors who can access a basket of private equity funds will. For these investors, this index is a cash management tool as they go through due diligence and fund allocation processes, while for mid-tier and retail investors who do not have access to private equity, or product structurers who need it for daily liquidity, listed private equity index products are alternative options," Dash says.

It is this desire for increased liquidity and transparency that is the driving force behind the launch of these various indexes. Private equity funds have specific investment and withdrawal periods, and can only be purchased during the ramp-up period. Investors typically cannot pull their money out of an investment, and are paid back through distributions, which are made as the fund realises profits from selling its constituent private equity companies, explains Dash. Private equity indexes, in contrast, provide intra-day liquidity.

"An investment in a structured product linked to a listed private equity index will have more liquidity, more accessibility to retail or mid-market investors and greater correlation to equity markets. Also, private equity fund investment means you are accepting internal-rate-of-return calculations and fund-house risk, while listed index products will have daily compounded returns and are more diversified among fund houses," adds Dash.

Another advantage is that the indexes provide broad exposure to private equity as an asset class. The performance of individual private equity funds can vary significantly, and the best-performing funds are often only available to key relationship clients. An investor looking for a direct investment in private equity might therefore end up investing in one of the lower-tier funds.

"Often, the best performer remains from one year to another, and so lots of money is often invested into that one fund. But if it closes, investors do not get any other choices than second- or third-tier funds, which are yielding lower returns," explains SG CIB's Benzimra. "There was a concern raised by the UK Financial Services Authority last November, stating that the industry needs to obtain more listed entities in order to get more liquidity. This is exactly what private equity indexes offer and there is a great future for this ahead."

Listed companies represent only around 15% of the private equity sector. However, they do provide an important entry point into the asset class for retail and mid-market investors who simply do not have the means or confidence to access private equity directly, says Thomas Salter, executive director in JP Morgan's equity derivatives group in London.

Nonetheless, large institutional investors are not expected to use index-linked products as substitutes for private equity funds. Rather, these products are more likely to be used for risk and liquidity management purposes, explains S&P's Dash. "For example, if an institution has a $100 million allocation to private equity but the due diligence will take three months, it might consider parking that in a listed private equity index product rather than a money-market fund."

While the number of private equity indexes is growing, so too are the number and variety of structured products available. "The structured product market has trended away from products with complicated payouts, moving towards providing investors with protected or leveraged access to exciting new asset classes and strategies," comments Salter.

At JP Morgan, products linked to listed private equity have ranged from capital-protected notes to bonus certificates and other products offering a degree of protection on the downside. Two recent product examples include a four-year capital-protected note paying 87.5% of the highest observed level of a basket of seven listed private equity shares, and a four-year certificate offering 120% of the upside performance on a basket of seven listed private equity shares, up to a maximum of 50% performance (corresponding to a maximum redemption of 160%). In the latter case, investors are exposed to downside risk if the basket finishes below 75% of its initial level. JP Morgan is also developing its own private equity index, based on the top tradable listed names, in partnership with a leading index provider.

ABN Amro's structured products range from certificates tracking the private equity index, to capital-protected notes, open-ended certificates, bonus certificates and constant proportion portfolio insurance structures.

"Investors have the option of capital-protected or products with more risk as part of a diversified portfolio," Thind says. "The products we tailor depend on the investor's risk appetite. The products are suitable for both retail investors with very little money to invest (denominations are as little as EUR100), as well as high-net-worth clients and also increasingly institutional investors. Clients like transparent, liquid products where the fee structure is reasonable and the added benefit is that they often outperform managed funds."

And ABN Amro has more products in the pipeline. "We already structure derivatives on our indexes and price options. Well-constructed indexes can be used for very complex structured products and we can easily launch exchange-traded funds (ETFs) on our indexes. Indeed, our certificates are a form of ETF, just different documentation," Thind adds.

Meanwhile, SG CIB has several structured products available, including delta-one structures, certificates listed in Stuttgart, Frankfurt and France, and an ETF (Lyxor ETF Privex) traded on Euronext, which already has EUR60 million in assets under management.

S&P's Dash is confident that the number of structured products based on its Listed Private Equity Index will also grow. Indeed, Barclays Global Investors has already issued an iShares ETF based on S&P's private equity index that trades in London, while other index-linked structured products are currently being marketed by dealers in Europe. An ETF in the US is also expected later this year, while index-linked products are already in the pipeline in Canada and Australia.

The provision of liquidity has to be one of the major benefits of index-linked private equity structured products. While the indexes may only represent approximately 15% of the private equity universe, they nevertheless reflect various types of firms, giving the investor a flavour of the buyout companies, say index providers.

However, the market needs to be careful to not overcomplicate the products, as ABN Amro's Thind explains: "One should also ask if complexity for the sake of it is a worthwhile end goal. In my view, clients must understand what they are buying and the inherent risks associated with investments. This is particularly true for private clients. Unexplained complexity is undesirable and hard to sell. If one thinks about it, there are enough risks in the listed equity markets. These are only compounded in the private equity markets by the nature of the underlying investment and in addition there are certain risks associated with exposure to private equity managers."