Private equity

Private equity is in vogue. J Sainsbury, the supermarket, is being stalked by a group of the world’s most established private equity houses. The possible takeover underlines the power of the buyout industry.

CVC, Kohlberg Kravis and Roberts and Blackstone Group are mulling an £11bn-plus takeover attempt of the supermarket chain.

But contrary to what you might expect, it’s not just big institutional investors who can earn big returns from investing in private equity deals like this possible one. Retail investors also have a chance to grab a slice of the pie.

So what is private equity?

The truth is it’s quite a broad definition. It can refer to any type of equity investment in an asset that isn’t traded on a market. Private equity investments include the following: leveraged buyouts, which use large amounts of debt to acquire companies; growth and venture capital; so-called angel investing, where funds are used to invest in fledgling businesses; and mezzanine capital, when riskier debt is used to acquire assets.

In many cases, the way private equity deals work is that big institutional investors put money in private equity funds which then invest in target companies. These funds can specialise in a particular type of private equity investment such as leveraged buyouts. Depending on the size of the stake in the company they hold, private equity funds can have a say in how companies are managed. Often, if they take a controlling stake in the company, they bring in new management teams that try to improve the value of the company.

Private equity can involve taking listed companies private. Funds can also be used to offer venture capital to businesses just starting out or even to help management to buy businesses from their current owners. Private equity investors tend to look to put money into underperforming businesses or those with growth potential.

How can private investors invest in deals?

Unless you have tens of millions of pounds at your disposal and are being wooed by the chief executives of private equity houses directly, there are two main routes: investment trusts and venture capital trusts. Of these two, investment trusts tend to be the more sensible option as managers are not constrained by the same investment restrictions that apply to VCTs, although the latter do have alluring tax breaks.

Some trusts invest in both private equity companies and funds. Others are similar to funds of funds in that they offer exposure to a variety of funds run by different houses.

“The advantage of these private equity trusts is retail investors can get involved in them at whatever size,” says Simon Elliott, a trust analyst with Winterflood Securities.

Some VCTs also invest in private equity. On the plus side investors in new issues enjoy a 30 per cent income tax rebate on their initial investment, provided they hold the VCT for five years, and there’s no tax to pay on income and gains. However, managers can only invest in companies with gross assets of no more than £7m prior to investing and £8m afterwards. This limits the manager to very small companies. And asset-backed businesses such as property and financial companies are also precluded. Therefore, it tends to be better to invest in private equity investment trusts.

What are some of the private equity trusts that financial advisers and analysts like?

Dunedin Enterprise, which invests in a broad range of UK companies with a view to making money over a two to three-year time horizon is one. Graphite Enterprise IT, which puts money in both private equity companies and funds across Europe is a second. Another is Pantheon International Participations, which is effectively a private equity fund of funds. It invests globally with a bias towards the US.

What are some concerns about investing in private equity funds?

Some analysts think listed private equity funds – the main private equity route for retail investors – will suffer from “cash drag” as the inflow of new funds leads to increasing amounts of cash sitting on their books while they look for suitable investments. Another worry among analysts is that leverage – the debt component of acquisition funding – is remaining higher for longer.

Traditionally, private equity groups gradually reduce the leverage on a deal by repaying the debt bit by bit. But low interest rates have encouraged them to keep leverage high, which increases returns in the short term but magnifies losses if the deal goes wrong.

Another risk for investors is that they will pick the wrong manager. In private equity the differences between managers’ performances are bigger than in mainstream equity funds.

What are returns like on these trusts?

Investment trust returns have been strong. On average, private equity investment trusts reported a 58 per cent rise over the past three years.

How far does private equity date back in the UK?

As far back as the 18th century, entrepreneurial types would look for wealthy investors to back their business projects. But private equity didn’t become a formal industry until the 1970s and 1980s when a number of the big firms were founded