Brent Sheather: Private equity funds stuff of legends

Maori legend says that Maui, half man half god, performed various heroic deeds including catching the sun, dragging the North Island out of the sea and disguising himself as a kereru.

The new legend of Maui was described in the prospectus of the Maui Capital Indigo Fund, a local private equity fund which was floated towards the end of the private equity boom in March 2008.

It spoke of heroic deals done with previous private equity funds and the historic performance of the Maui Capital team with several investments apparently returning to shareholders multiples of five to 10 times the sum invested.

But this is legend - reality has turned out a bit differently for Maui Capital Indigo Fund investors so far. The share price of this fund, after 18 months, is unchanged from cost, which may be disappointing for shareholders but is actually a pretty good effort relative to other private equity funds.

But first some background. The MCIF is an unlisted fund designed to invest in growing companies, build and develop them and potentially sell them at a higher price.

To its credit, MCIF management has been in no hurry to invest shareholders' funds with 5c of capital paid in March 2008 and a second call of 10c payable just this month.

But a big issue for some investors in the MCIF who became shareholders after the fund's initial marketing has been the liability associated with its partly paid shares in this new austere, post-crash environment.

Early last year, with private equity in its ascendancy and apparently only available to the rich and famous, retail investors were happy to pay 5c now with an additional 95c to be called in the future.

This leverage was viewed positively back then in much the same way property investors put a small deposit down on an apartment with the intention of flicking it on for a big profit just before the final payment was due.

How things have changed. Overseas, the private equity bubble has well and truly burst with private equity funds like Schroders and Candover, on the London Stock Exchange, having fallen by almost 90 per cent from their peaks and trading at average discounts to the estimated value of their investments of 30 per cent and more.

In fact the London Financial Times reports that institutional and high net-worth investors, who in the bull market committed to pay further substantial sums to private equity companies, were earlier this year virtually giving away their initial interest so they didn't have to come up with further money.

Partly paid shares can be something of a trap for those people who don't understand how they work. At least with finance company debentures, if you invest $1, that's the most you can lose. With partly paid shares, it is possible to lose much more than your initial investment.

In the case of MCIF, the $1 shares were payable firstly to 5c with a further 95c payable at some date in the future and investors are legally required to make that 95c payment sooner or later.

Maui Capital advises that in the original marketing of the fund investors clearly understood their total commitment and made investment decisions on that amount.

Locally, some investors have discovered that their "risk profile" has contracted somewhat since their original commitment to MCIF and today they would rather apply new funds to lower-risk, income-producing assets, like bonds.

What makes the prospect of having to make an additional equity investment in MCIF problematic for some investors is the dire state of the rest of their portfolios.

In looking at the portfolios of a few small retail investors with holdings in this fund, it appears that the fully paid value of the fund will be a relatively big proportion of their investment assets.

In the cases that I have seen, the fund, once fully paid, will represent around 16 per cent of the equity component of the investment portfolio when common sense and best practice tells us that private equity should, if in fact it is deemed appropriate for a small investor, be in most cases a very small proportion of the share portfolio.

The NZ Super Fund, which has a much longer time horizon than your average retail investor and no need for income, has only 1.1 per cent of its assets in private equity.

What's more, that the MCIF is high risk is official - the Securities Commission required it to set out "a prominent statement to the effect that investors should regard this investment as high risk".

If many retail investors have high weightings in the fund, this raises the issue as to whether MCIF may have been mis-sold to some people. Certainly, it is not hard to find reasons why advisers would be so enthusiastic about the fund. For a start, fully 1.5c of the 6.5c initial subscription to the fund went to the adviser in commission.

But the good news is that there is a "grey" market in MCIF shares and shareholders can sell out at around the price they paid for the fund; that is 15c, at present. This is a particularly good result because many private equity funds have fallen substantially in value between the time MCIF was launched and today.

Furthermore, most private equity funds trade at a discount to NAV.

So what about the fund itself, how is it doing? It is early days yet but the March 2009 accounts of the MCIF don't make good reading: the fund earned just $400,000 in interest in the year but paid $2.5 million in management fees.

Management fees are very high compared to index funds with an annual management charge of 2 per cent a year plus 20 per cent of all profits above an 8 per cent return. However, this is apparently par for the course in private equity.

In comparison, low-cost index funds offering better diversity and a dividend are available with a management fee of around 0.2 per cent and no performance fee.

But MCIF appears to be being managed well. Management has spent just 15c per dollar so far, thereby avoiding the steep decline in prices of companies as demonstrated by sharemarkets around the world in the past 12 months.

Thus far, anyway, Maui has avoided throwing its money down the whare paku.

But the short-term outlook is cloudy: private equity has two big problems at present - debt funding is not as readily available as it once was and exit opportunities like listing a stock on the sharemarket are limited.

What's more, as prices, and thus earnings multiples, of listed companies are low, the potential to make super profits by buying a company at four times earnings and selling it at 15 times is limited.

The flip side, of course, is that many companies are cheap and some larger companies are looking at rationalising their businesses.

However, thus far this does not appear to have translated into a lot of opportunities for MCIF - it has made just one investment and that is in a company listed on the Australian Stock Exchange.

Mum and Dad could buy shares in this company directly and avoid the management fees and the performance fee. However, they shouldn't because ownership of one small company doesn't make any sense for prudent investors from a diversification point of view.

It looks like, as far as private equity goes, MCIF has been a good investment. But it really is only appropriate for genuine high net-worth individuals and institutions with no need for income, a long time horizon, and perhaps a tolerance for risk like Maui himself.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.