Episode 29: Private equity spotlight: Portfolio benefits and more

Let’s cover private equity basics. What is it and how does it work?

[Wesley Blight 0:59] Happy to do that, Alex. We don’t actually get asked that question all that much, but I think it’s a really important one. Because of the growth of private assets overall, it’s been a massive growth story over the last 10, maybe even extending back over the last 20 years, but really over the last 10. And that includes real estate, private credit, private equity, infrastructure, any business that needs capital, but they’re not actually accessing that capital from public markets.

Private equity is the biggest and probably the most commonly known private asset class, but not necessarily all that well known, if that makes sense. What it is, it’s ownership of private companies. So sometimes that ownership can happen before a company is public. And sometimes it can happen after a company is public. And typically, what you’ll see is it’s providing financing, to companies that need an injection of equity capital.

So that can range anywhere from a company that is really young and early in the early stages of development that’s really called venture capital. Then you can move into businesses that need capital for growth. So, they need capital to expand their production, expand their regions, hire new people, or other means of generating growth. So, they need capital to make that happen. Then there’s the acquisition of more mature companies, those are called buyouts. I would argue that the bulk of private equity that we read about takes place at that level. And then the last stage of a private equity company would be a capital that goes in and seeks to turn around distressed situations.

So the way it works is, you’ll have a variety of investment funds that go out and look to raise capital, that capital comes into the fund and then the company that has raised the capital, or the fund that has raised the capital will look to deploy it by making commitments and making investments into those underlying businesses that need the capital for growth, need the capital for a turnaround situation, or need the capital to really get themselves up and running.

What are the asset classes merits in portfolio construction and to our investors?

[Belgacem Ghazi 3:24] Sure, Alex. Well, for many years, private equity has been a niche in the investments universe, dominated by ultra-wealthy individuals and institutional investors. However, today, we’re seeing that trends are increasing the prominence of the asset class and reinforcing the case for including it in long-term-oriented portfolios across all types of investors.

We believe bringing this asset class in the portfolio confers some important benefits. This includes access to a broader set of potential opportunities, and the ability to invest at an early stage in a company’s existence as Wes mentioned.

Another merit is that, in our opinion, that private equity offers an attractive risk reward profile. And the main characteristics that supports this are; first, the private equity managers are actively involved in deciding on the strategic direction of their companies, and have specialist value creation teams that are dedicated to a singular task which is actively adding value to increase the return as much as possible in the long run.

Second, private equity investments are less volatile relative to public investments in the sense that they are less affected by the immediate economic- and market-based trends. The value of private equity investments is tied to company metrics and performance, they are not influenced by swings in the market.

And finally, one of the major benefits of private equity is that private equity funds are not necessarily coupled to a particular market, and while economy conditions may affect the performance of portfolio companies at a fundamental level, private equity managers seek to create value over a long term and will not rapidly enter or exit investments based on market sentiment.

The same goes for private equity investors who similarly seek out long-term returns. As a result, private equity funds have low correlation with public markets, making them an excellent diversifier. So, in balance, private equity enhance portfolio returns while providing valuable diversification as well as the access to the significant investable opportunity set that exists across the universe of private companies.

Since the last private equity update, interest rates are a bit higher, we saw some issues pop up across U.S. regional banks, how have things played out for private equity since then?

[Belgacem Ghazi 6:32] In fact Alex, the impact of [the] regional banks crisis has not been as high as expected. Companies we are invested in are more cautious in how they are managing cash. Fund managers are similarly cautious, and the direct impact has been more focused on venture growth, which we don’t have a lot of exposure to.

We reached out to the fund manager and confirmed that all portfolio companies have access to their fully insured deposits, have credit lines that are functioning normally and actively are evaluating opportunities to diversify their banking relationships.

Regarding the higher interest rate effect, indeed, it did impact the investment valuation. The private equity valuation overall declined, which is good news as new investors will have opportunities of investing at lower entry point, and less good news for existing person as their investment value decline. However, the beauty of long-term investment is that they can continue to hold their investments until their values ramp up again. And this is the case where our current private equity solution where some of the investments were expected to be realized or sold during this year, 2023. But given the lower valuation, their exit timing has been postponed for at least a year.

How has the original MD Platinum Global Private Equity Pool performed?

[Wesley Blight 8:17] Alex, we’re really happy with how the pool is performing, it is well ahead of expectations in terms of having made investments ahead of the pace that we expected to be able to make them. So that’s referred to as pacing. And in terms of performance results, we’re really happy there as well.

So even with the challenges that were presented by the global pandemic, 100% of the pool’s assets, so that’s the capital that we raised from MD clients, has been committed to underlying investments, and 67% of that capital has actually been deployed or invested in companies. Now 50% of the program is invested in primary funds, 32% is invested in co-investments and the rest is invested in secondaries.

And the latter two, so the co-investments, that’s a direct ownership of a company alongside another fund. And then secondaries, that is taking advantage of the secondary market where primary funds, so those are the initial funds that I talked about earlier are raised, they can be bought and sold in the secondary market. And by accessing both co-investment opportunities and secondary opportunities, that can help them manage the J-curve.

And the J-curve is a typical experience for a private equity investment where in the early years, they actually have a negative IRR (Internal Rate of Return), because you’re taking your committed capital and you’re going out trying to find investment opportunities that are suitable and usually because of fees and the time it takes for an underlying company to sort of get up and running and really make positive returns, that causes that negative drawdown for a period of time. And then you get a recovery. And that’s what causes that J.

We were able to avoid that J-curve with our 2018 vintage, because of the co-investment opportunities and secondary opportunities, allowing that positive cash flow to come in more quickly than we anticipated. At the end of September, the net IRR for this pool was 17.6%. That is well ahead of public market equivalents. In fact, it’s 1300 basis points ahead of the public market equivalent.

What is MD’s approach to private equity investing?

[Wesley Blight 10:46] Yeah, we’re really proud of the process that we built. I mean, I’m very confident in how robust, not just our search process, but our portfolio construction process really is. And that’s true across all the mandates that we manage, but for private assets and private equity in particular, we’re really focused on how do we get to realizing the objectives that we’ve set in the most efficient way possible. And what I’m talking about there is, we’re trying to, in the case of private equity, we’re trying to hit an IRR target between 10 and 12%.

And what we want to do is make sure that in pursuit of what is really kind of a lofty return objective, that we’re doing it in a well-diversified, appropriately managed portfolio from a risk perspective. So, with that in mind, we screened over 800 managers that were offering new investments in private equity from across the globe.

We also reached out to those where we have an existing relationship. Amongst those that are looking to raise capital with a strategy that focused on either global private equity, a European private equity or U.S. Now in North America, and the U.S. in particular, that’s the deepest, oldest, most robust markets. So, we’re going to have the bulk of our investments there. We recognize there are tremendous opportunities in Europe, but we’re probably going to dial back, and Bel is going to get into this a little bit more, but we will probably dial back the exposure that we have to China.

As we work through that search process, we started to eliminate those that have too narrow a focus in their strategy. And the reason for that is what I talked about earlier, when we’re thinking about risk management, we’re looking to maximize the diversity in pursuit of realizing our target return. And those that are really focused on, say, country specific technology companies only, that doesn’t really fit with the breadth and diversity that we’re looking for.

And we look at lifespan, we’re looking to make sure that that total time from the end of the commitment period through until the end of the life of that fund, so that’s the term to lifespan, we want to make sure that it lines up with our 10-year lifespan with two 1-year extensions. And we’re also looking for a good alignment of strategic intent.

So, from the more than 800 managers that we screen, we’ve got ourselves down to a much smaller number, we will then send out an RFI, which is a request for information. And it pulls in all sorts of information around how they go about sourcing opportunities, how the manager goes about evaluating those opportunities, so really their diligence process, and what we’re looking for is a strategic alignment with what we’re trying to do. And we’re looking for those that have a philosophy that’s align with what we’re seeking to do as well. So, kind of strategic intent, philosophy, both aligned with what we’re looking to do.

The philosophy needs to make sense, we’re looking for companies that have a well-described thesis for how they’re able to realize their objective. And then the process is well-connected to that philosophy. And it’s robust, the process needs to lreally tie into the philosophy, and you need to be able to tie a nice direct line between that process, that philosophy and the track record that’s been realized.

And then we want to understand from a people perspective, that the people who are involved in sourcing, debating and selecting the investments that they want to make, are consistent with the strategy that’s currently being offered so that you can get some confidence that past results, although they’re definitively not guaranteed, you’ve got a higher probability of them being repeated in the future.

Then from there, as we’re kind of working through an understanding of what that team structure looks like, and what their decision-making framework looks like, we have an eye to how they manage the businesses that they own. And sometimes there can be a little bit of inconsistency between an identified opportunity and the ability to realize the value that’s been created through the work. And we want to make sure that there’s a lot of consistency there so that you can see the thesis for why the fund manager wants to buy a company through to them executing that strategy that creates the value, and then all the way to their exit strategy. So, when they go about selling that company, regardless of how they’re going to exit the strategy, when they go about selling it, how are they able to realize the value that they had created, which turns into us realizing the IRR that we’re seeking.

So, we are in the midst now of doing our diligence, with those companies that have returned the request for information. And those are sessions we’re really going deep and understanding the decision-making framework. Once the decisions are made, how do they go about realizing the value that they’re trying to create?

What can you tell us about the new MD Platinum Global Private Equity 2023 Trust? What can we expect and is anything new or different from the existing vintage?

[Belgacem Ghazi 16:01] Definitely, we are excited to launch the brand-new MD [Platinum] Global Private Equity 2023 Trust, which will be similar to our 2018 vintage in terms of strategy type, allocation and geographical allocation. Similar to our successful private credit solution being built by the Multi-Asset Management Team, we will be selecting the underlying funds and managers to fulfil targeted allocations.

Strategically, we will target a higher allocation to secondaries compared to the 2018 vintage, up to 40%. And the main reason is the role secondary funds play in the J-curve. And secondary funds typically return investors capitals sooner because the buyer stakes at a later stage in the private equity lifecycle. And finally, investing in secondary funds offer greater investment opportunities as ongoing liquidity needs and portfolio rebalancing are expected to maintain a high level of market activity in this space.

The information contained herein provides key information about the respective MD Platinum™ investments and is not intended to be taken by, and should not be taken by, any individual recipient as investment advice, a recommendation to buy, hold or sell any security, or an offer to sell or a solicitation of offers to purchase any security. The Platinum investments described in this document are subject to additional terms and conditions set out in the Platinum investments’ operative agreements and regulatory suitability requirements as considered by your Portfolio Manager, MD Private Investment Counsel, an operating division of MD Financial Management Inc. The Platinum investments’ operative agreements will also set out additional information about the investment objective, terms and conditions of such fund, tax information and risk disclosure that are a material terms regarding a fund. Any investment in a Platinum investment would be speculative and would involve significant risks. The information and strategies presented here are not suitable for U.S. persons (citizens, residents or green card holders) or non-residents of Canada, or for situations involving such individuals. Employees of the MD Group of Companies are not authorized to make any determination of a client’s U.S. status or tax filing obligations, whether foreign or domestic. The Platinum investments are intended for individuals that have a discretionary managed account with MD Private Investment Counsel.

No guarantee or representation is made that any MD Platinum investments will achieve its investment objective. In addition, there are risks associated with investing in the MD Platinum investments that are not applicable to typical investments in the public equity markets. These risks include, but are not limited to, the following: private equity investments are speculative and involve a high degree of risk; an investor could lose all or a substantial amount of their investment; interests in private equity investments are illiquid and there is no secondary market nor is one expected to develop for interests in such investments; there are significant restrictions on transferring private equity investments; private equity investments experience volatile performance; private equity funds are often concentrated and lack diversification and regulatory oversight.

Certain information contained herein constitutes “forward-looking statements.” Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As a result, no reliance should be put on such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements. MD Platinum investments are intended for discretionary managed account clients of MD Private Investment Counsel, a division of MD Financial Management Inc. All fees and expenses associated with and applicable to the MD Platinum investments may be higher than fees and expenses in public security funds.