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November 6, 2006 8:13 pm

The hunt for liquidity hits a dry patch

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It seems that high net worth and other retail investors are not the enthusiastic buyers of publicly traded private equity vehicles that some funds hoped they would be.

In a few short months, the market has become saturated. Kohlberg Kravis Roberts raised $5bn through its initial public offering on Euronext in May, but Apollo Management subsequently struggled to raise $2bn, and both have been underwater ever since. At the beginning of November, KKR was trading at a 12 per cent discount. London-based buy-out firm Doughty Hanson pulled its planned €1bn ($1.3bn) IPO on Euronext in October. “Apollo had trouble raising the amount it wanted, so other funds are pulling back. There’s a fear that a lot of the real interest may have been soaked up by KKR,” says Kelly DePonte, partner at San Francisco-based alternative investment firm Probitas Partners.

These new public funds, essentially blind pools of capital that can be invested in buy-outs and other investment opportunities, have listed on Euronext or Aim to avoid the more onerous and costly regime imposed on the US by Sarbanes-Oxley and the 1940 Investment Company Act in the US. But would private equity firms be any more popular with investors if they listed in the US?

Demand for private equity products from the US high net worth market is increasing. Peter Aliprantis, head of alternative investments for private banking in the US at Credit Suisse, says that while US endowment funds are scaling back their exposure to private equity, high net worth and ultra high net worth investors are jumping in. According to the Merrill Lynch and Cap Gemini 2006 World Wealth Report published in June, high net worth allocations to private equity are growing while their allocations to hedge funds are diminishing.

Lawyers who have worked on recent Aim and Euronext private equity IPOs say that if private equity funds listed in the US they could take advantage of the far bigger investor base and the culture of venture capital investing. “Private equity firms will have to overcome the psychological barrier of providing greater transparency in their operations to list in the US but it’s likely that the greater liquidity available will ultimately outweigh that,” says Andrew Caunt, partner at McDermott, Will & Emery.

Rick Mitchell, another partner at the firm, says the bigger deal sizes obtainable in the US could mitigate the extra compliance costs. “Given that private equity funds are essentially large piles of money with a few people on top, without a large administrative staff in place, it makes sense for them to list where the disclosure requirements are less onerous. But once a deal gets big enough, a couple of extra million dollars in compliance costs doesn't bite that hard.”

If more US listings do follow, Mr Aliprantis thinks it would be a positive development for high net worth investors in the sense that private equity IPOs open up the market. “Predominantly, private equity funds have targeted institutions and ultra high net worth individuals, who can allocate $2m -$3m to a private fund. Now they are targeting investors with maybe $200,000 or $300,000 to spend. For smaller investors, it provides more access to private equity than they’ve had before.”

There have already been public offerings of private equity in the US, although with narrower investment mandates than the funds recently launched on Euronext because of regulatory constraints. In May, Compass Diversified Trust raised $202.5m on Nasdaq, but this cash will be deployed in a pre-identified pool of investments. KKR launched the IPO of KKR Financial, a real estate investment trust, on the New York Stock Exchange last year. Most public offerings in the US by private equity firms have been launched as business development corporations – specially regulated retail investment companies that are focused on mezzanine and debt investments.

However, Mr DePonte argues that efforts by private equity firms to list in the US also have been short-lived and largely unsuccessful because, as with the recent private equity IPOs on Euronext, investors soon realised that private equity firms were taking management fees up front without committing themselves to a date by which they would invest their cash. After Apollo launched an IPO of a business development corporation on Nasdaq in April 2004 and raised $930m, other private equity firms made nearly $8bn of filings for similar business development corporation IPOs. The Apollo IPO performed badly in its first year and by the end of 2004, most of the filings by rival firms to do similar deals had been withdrawn.

Even if future US listings are a success, now other products are competing for the attention of the US high net worth market. PowerShares launched the first private equity exchange-traded fund on October 24. There are also a growing number of private equity funds of funds. Instead of putting all their cash into the IPO of a single name, both offer high net worth investors diversified exposure to the private equity market.

Whatever the product, new private equity investments should be approached with caution. KKR may have €5bn to play with from public investors in its Euronext fund, but it is also about to close its new 2006 global fund, set to exceed $16bn, and the biggest of its kind in the world. New cash being raised in the private and public domain is ultimately chasing the same deals, when the market is already fully invested.

Mr DePonte says that if high net worth investors are logical, they should think about the amount of different funds raising cash at the moment. “There is lots of money being invested in megafunds right now. Does this mean it’s a good idea? Some people would
say no.”

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