Listed private equity exchange-traded funds (ETFs) have been on a tear this year, led by stocks such Blackstone, Carlyle, KKR & Co and 3i, which have added between 15% and 25%.
The two main indices measuring the performance of this segment of the financials sector, the S&P Listed Private Equity Index and the Red Rocks Global Listed Private Equity Index, both of which are investable via ETFs, have gained 9.8% and 9.5% respectively.
While listed private equity can be seen as an indirect leveraged play on the stock market, the performance of these stocks is due in part to rising stock markets, which have increased the value of their private equity investments, but also to improved conditions for mergers, acquisitions (M&A) and initial public offerings (IPOs), which in turn could lead to private equity firms realising performance fees as they offload portfolio investments.
A recent report from Preqin, a provider of data and intelligence for the alternative investments industry, revealed that there were currently 42 private equity and venture capital-backed companies in the IPO pipeline, having filed with the relevant listing authorities. If these IPOs get away, this could generate substantial income for their private equity sponsors.
However, while the IPO market is looking much more viable – recent successful IPOs include Norwegian Cruise Lines, TRI Pointe Homes and CyrusOne – the market environment appears particularly ripe for strategic sales (also known as trade sales), with a number of private equity-backed companies known to be in talks with potential buyers.
According to the latest Morningstar M&A Insights report, strategic transactions are becoming increasingly attractive to management as companies are sitting on significant amounts of cash that need to be deployed, operating margins are near their highs and will be difficult to expand further, and organic growth is difficult at best in a low-growth environment. Considering net debt leverage is generally low at most companies and debt is cheap, most issuers have plenty of bandwidth to finance deals.
RJ Hottovy, director of equity research at Morningstar and co-author of the M&A Insights report, said: “We think 2013 will bring an uptick of deal activity, after we’ve seen a decline in the number of deals and very little growth in the total value of deals in the last two years. While we don’t see the potential for huge blockbuster deals in the near term, there’s no shortage of companies with available capital on their balance sheets and high operating margins, fewer organic growth opportunities, and candidates with attractive valuations.”
Similarly, Bridget Freas, a senior analyst at Morningstar, said: “We are expecting a pick-up particularly in strategic acquisitions. We do think that the leveraged buyout market is open. We do see opportunity for financial transactions, but I think particularly, if you look at management teams, they are sitting on stockpiles of cash. That’s the number-one thing. There is only so long that executive teams can wait on pulling the trigger and actually deploying that capital.”
Freas added: “The other thing, I would say is, for a lot of sectors, corporate profit margins are at a cyclical peak. So, it’s going to be hard to continue to grow the bottom line without new sources of earnings, and we think one of the easiest ways to achieve that is through acquisitions – definitely new sources of growth and just a way to continue to drive the bottom line.”
First up is the iShares S&P Listed Private Equity ETF (IPRV). This ETF tracks the S&P Listed Private Equity Index, an index comprised of 43 leading listed private equity companies that meet size (minimum $150m market cap), liquidity (three-month average daily traded volume of $500,000), exposure, and activity requirements. The index is designed to provide tradable exposure to the leading publicly listed companies in the private equity space. Major holdings include Blackstone Group, Carlyle Group, American Capital, Brookfield Asset Management, Ares Capital, Wendel, 3i, KKR & Co, Apollo Investment and Partners Group. The fund is listed on the London Stock Exchange, Borsa Italiana, Deutsche Börse, NYSE Euronext Amsterdam, NYSE Euronext Paris and SIX Swiss Exchange, and comes with a total expense ratio (TER) of 0.75% pa.
The second ETF in this space is the PowerShares Global Listed Private Equity ETF (PSSP). This ETF is benchmarked to the Red Rocks Global Listed Private Equity Index, an index which, like the S&P index, tracks the performance of publicly listed private equity firms. The index has a lower minimum market cap requirement ($100m) and moderately less stringent liquidity requirements ($250k average traded daily volume), resulting in a broader index of 62 constituents. Major holdings include Blackstone Group, Onex Corporation, Partners Group, KKR & Co, Melrose Industries, 3i, Ratos, Wendel, Hal Investments, and Leucadia National. The fund is listed on the London Stock Exchange and comes with a TER of 0.75% pa. An NYSE Arca-listed US-domiciled version of this fund is also available (PowerShares Global Listed Private Equity Portfolio ETF (PSP)).
The performance of the two funds has been broadly similar over the past few years and year-to-date, and their underlying indices are fairly well correlated. The only major characteristic difference between the funds is the country exposures, particularly the US weight. The PowerShares fund, which is benchmarked to the Red Rocks index, is more diversified at the country level, with the US representing only 34.8% compared to 63.8% for the iShares fund. The Red Rocks index is also rebalanced on a quarterly basis, compared to semi-annually for the S&P index, thus making the PowerShares fund more responsive to changes in the private equity industry.