Why private equity firms are opening the door…

Johanna Englund: Morningstar Senior Equity Analyst Johann Scholtz initiated coverage of three large European private equity firms and assigned them all a narrow rating.

Johann, what is behind this rating for EQT, CVC and Partners Group?

Johann Scholtz: Yes. Well, for both traditional and alternative asset managers, we usually tend to find pitfalls in intangibles and switching costs. So we think clients of these three firms will find it challenging to switch because, as private market investors, you’re typically locked in for four to 20 years. And then also customers will have to incur significant due diligence costs if they want to switch to another provider, again making switching difficult. And then in terms of intangibles, we think all three have a strong track record of performance, which is vital in private market investing. And a key factor in achieving this record performance is the strong proprietary transaction flow they manage to generate. And building a string of deals is something you can’t replicate overnight.

England: But you’ve noticed that private equity is opening up to retail investors. Why is that? And what might the implications be?

Scholz: Yes, I think it’s a bit of a change in the regulatory landscape. It’s not fully opening up to all retail customers, but it’s definitely — in the past, it used to be reserved for ultra-high net worth individuals, it’s kind of opening up to, you name it, the mass affluent market. now. I think for private market firms, it’s a bit of a positive, it opens up a new market for them. However, we believe this could bring greater regulatory scrutiny to the industry. And we’re a little concerned about the impact that this might have on the very high fees that private equity firms have historically been able to charge.

England: I also found it interesting to look at one of the other ratings that you assigned to all three of these firms where you gave CVC a poor equity allocation rating, quite a contrast to the other two firms. What are they doing that you don’t like in this area?

Scholz: Yes. Our capital allocation methodology looks at three different criteria. We look at the strength of a firm’s balance sheet, the quality of its investment decisions, and then we also assess the distribution of shareholders. Now, what we don’t like about CVC is that their balance sheet is the weakest of the three. It has the most debts on the balance sheet. And we question the need for a private market firm to have any leverage on the balance sheet at the firm level, when you already have a lot of leverage on portfolio companies sitting in funds. And then secondly, CVC, which only recently listed, got a weird split of performance fees, or carried interest, as it’s known in the private equity world, whereby some of the founding shareholders get to act before the shareholders ordinary in the carried interest. And we don’t find this distribution particularly beneficial to common shareholders.

England: So finally, for investors interested in private equity firms, what would you say is important to watch out for?

Scholz: Yeah, I think with private market firms, you really have to focus on the management fees, the part of the revenue that comes from recurring management fees, as opposed to the part that comes from carried interest, which tend to be quite volatile and cluttered and can skew your analysis quite a bit. So I think it’s very important. And then I think it’s also important to note that all three of these different firms have their own unique advantage or niche that they focus on. EQT, for example, is known as a technology and healthcare specialist. So you can almost see them as a more growth focused investor, while CVC is more of a traditional private equity player. And it focuses more on established firms in its investments. And then Partners Group takes a completely different approach and really focuses more on the needs of investors. And it tries to tailor investment solutions in the private equity world that match the liquidity and risk profile of its clients.

England: Thank you so much for joining us today, Johann. And until next time, I’m Johanna Englundh for Morningstar.