By Diane Harrison
Prior to the mid 2000s, private equity represented the de facto route to long-term appreciation for investors seeking to access investment strategies yielding double-digit returns. After the credit crisis of 2008 effectively closed the doors on efficient and profitable exits for many private equity funds, investors found their capital locked up in “zombie funds,” unable to exit and redeploy on schedule, and gathering excessive management fees. Investors trapped in this situation are subject to management fees, typically 2%, well beyond the anticipated 10-12 year lifespan of the fund, despite the fund offering little hope of returning a decent profit to the limited partners.
The long slow road to nowhere
The Wall Street Journal recently ran an article on March 31, 2015 that gives focus to this issue: Palico SAS, which operates an online marketplace, said in a report this week that the median life span of a private equity fund—across all regions and sectors—had hit 13.2 years. The figure, which is based on 200 funds dissolved last year, has increased from an average life span of 11.5 years in 2008. Palico said it meant investors faced lower-than-expected annual returns and potentially serious liquidity problems. It attributed the longer life spans to drops in asset valuations in the wake of the dot-com bubble of 2000 and the financial crisis in 2008.
Faced with uncertain liquidity and fee obligations potentially gobbling up expected returns, investors are eager to find alternative sources of opportunity. One such option is an investment strategy representing an amalgamation of private equity-like focus contained in a hedge fund-like structure. Managers who offer funds that provide shorter time frames to investment exits, greater liquidity through a hedge fund structure, and employ the event-driven skill set that identifies and manages an investment portfolio yielding private equity-like returns are finding increased interest from an investment community seeking returns married with reasonable liquidity.
Focus and execution spell results
This approach to hybrid equity typically involves identification of potential investments, through the small and mid-cap space, by managers who have a specialized ability to locate opportunities that can fit target return expectations into this shorter time frame to realization. Although at a relatively early stage of development, the investment universe appears to be large enough, and the change elements broad enough, to provide a robust field of potential equity ownership to meet both current and growing demand.
Some of the common characteristics of these hybrid equity portfolios include individual investment holding periods averaging 2-5 years, sector or specialty focus showcasing the portfolio manager’s strength in identification of opportunity or ability to effect change within an activist strategy, and special situations that potentially offer shorter duration time frames to unlock liquidity to meet both redemption needs and portfolio position turnover and growth.
There are numerous constructs that hybrid equity portfolios can take, and many sectors in which managers are seeking to build them. Technology and health care are two current popular areas, but clean energy and communications services are also gaining focus from investors and managers. Regardless of the market segment, these hybrid equity approaches have some common elements contributing to their success over a more traditional long-only equity portfolio. Three of these include better long-term value appreciation, a sharper strategic focus, and an addition of outside industry expertise to the board.
The early bird gets the worm
Long-term value appreciation comes from the early identification of potential growth and the possibility of a catalyst on the horizon that will impact the company or industry sector directly. Managers with a specialty focus or deep knowledge of a particular industry segment are able to uncover these change elements prior to general market knowledge and buy in (or sell off) specific companies that will benefit (or suffer) from the action to come. Deep research, an extensive network of industry experts, and a strong diligence process to vet such potential investment ideas are critical factors to own for managers executing this value identification within their investment universe. Prospective investors should probe on these skills when evaluating such investment strategies for their portfolios.
An eagle eye brings the vision into focus
Once an investment target is identified, having the ability to see what’s currently holding back a company from full potential and being able to implement an action plan to bring the potential to realization is what is meant by having strategic focus. Activist investors with a positive spin are interested in bringing their specialized management ability and operational expertise to bear on their investments and strengthen a company from one or more perspectives over time to achieve a higher level of performance. This typically means making management changes or additions to the firm, shoring up or streamlining operational practices, implementing better corporate governance throughout the firm, and improving productive capacity through the addition, editing, or updating of current company products or services. The ability to bring this level of impact to multiple companies within a hybrid equity portfolio requires a manager with the capacity to execute long-term, phase-driven strategic plans and manage the process from start to finish. Investors will want to find managers with a proven track record of such success when considering investing in such a process.
Who’s driving the bus and where is it going?
Finally, hybrid equity managers who use an activist strategy for some of their portfolio holdings will ultimately seek to add board and advisory members to a company. These outside advisors will generally bring a level of industry expertise and contacts to the firm that it did not possess before. A large part of an advisory board’s value to a firm is to lend a strategic view and guidance from outside the day-to-day operational focus management has in running the firm. The combination of fixing what isn’t working as well as it can and course-correcting the growth path of the company’s future direction with the assistance of a broadly experienced and influential advisory board can make for a winning combination in achieving long-term appreciation for such investment companies.
Sometimes briefer is better
In the wake of the financial crisis and liquidity lock-ups, investors want to be sure that their current investment dollars are working hard yet remain reasonably accessible. The major benefit of hybrid equity portfolios is not the profit appreciation that hopefully occurs, but that this appreciation is realized in such a manner that allows for liquidity for the partners participating in the fund structure. While all the following characteristics described help achieve the individual appreciation of the portfolio companies, the manager of a hybrid equity portfolio offering needs to be sensitive to the fund’s ability to meet periodic and regular liquidity needs of its limited partners without sacrificing the growth and target objectives of the fund itself. A unique balance to be sure, but perhaps the most significant benefit that a hybrid equity portfolio manager can promote to new investors.
Diane Harrison is principal and owner of Panegyric Marketing, a strategic marketing communications firm founded in 2002 and specializing in a wide range of writing services within the alternative assets sector. She has over 20 years’ of expertise in hedge fund marketing, investor relations, sales collateral, and a variety of thought leadership deliverables. In 2015, Panegyric Marketing received AI’s awards for Best Financial Services Marketing & Communications Firm and Business Excellence in Strategy & Positioning Statements – USA as well as M&A’s Excellence in Financial Services Marketing – USA, and Best Financial Marketing Firm – USA. The firm also won consecutive year awards in 2013-14 as IHFA’s Innovative Marketing Firm of the Year and AI’s Marketing Communications Firm of the Year- USA. A published author and speaker, Ms. Harrison’s work has appeared in many industry publications, both in print and on-line.