By Hamlin Lovell, NordicInvestor
Veritas’s private equity investments have fairly simple return targets: to earn a premium for illiquidity and complexity, they should outperform the group’s public equity investments. They should also beat relevant private equity benchmarks. Both goals have been achieved over multi-year timeframes.
Veritas, which is headquartered in Turku, recently merged with Pensions-Alandia, which is based in the Swedish-speaking Aland islands. Veritas manages over EUR 3 billion in total. Its private equity allocation is around 6.8%, of which Wickstrom is responsible for the 5.5% invested in external managers. There is also 1.3% in direct investments; illiquid private debt is separate and below 2% (and hedge funds are another sleeve).
Most of Veritas’ private equity investments are primary, though it can access the secondary market as and when needed. Veritas has not invested in publicly listed private equity companies, which tend to trade at a discount to net asset value, partly because adequate liquidity can be obtained through the secondary market.
Veritas has a small amount of exposure to venture and growth private equity, but is predominantly invested in management buy-outs, particularly in the mid-market segment where, “we see wider performance dispersion and therefore more potential to add value through manager selection and participating in smaller funds” says Wickstrom, who was previously CEO of AIM Capital Oy in Finland.
Of course, part of the return pickup from private equity comes from the leverage used and average levels of leverage are higher than for public companies. “The skillset needed to successfully manage leverage is one contributory factor to returns” says CAIA charterholder, Wickstrom. In terms of financial engineering, a leveraged buyout (LBO) can reduce a company’s weighted average cost of capital. On top of that, operational improvements from cost-cutting, efficiency enhancements, and merger-related synergies can expand earnings.
Naturally Wickstrom is mindful of leverage risks at this point of the cycle. In 2018, the proportion of mid-market private equity loans using at least six times leverage reached a record level of 49%, surpassing the pre-crisis peaks of 2017, according to Thomson Reuters. Moreover, this headline figure may understate true leverage, to the extent that the denominator of the equation – EBITDA – is being inflated by various adjustments and add-backs, including anticipated merger synergies that may or may not materialize. “Credit investors are starting to demand higher yields and push back on so-called covenant-lite and due diligence-lite deals that are often executed in a rush” says Wickstrom.
Given this backdrop, she is focused on, “finding the best investment managers who can source investment opportunities without doing the most competitive deals”. This is not an easy task with billions of ‘dry powder’ sitting on the sidelines increasing the level of competition for some deals, but Wickstrom see it as increasingly important to identify niche players who can obtain a competitive edge without paying top dollar for deals.
Private equity managers can specialize in geographies or industries, or be global and generalist. Wickstrom sees merit in all of these models and Veritas does invest with both global and pan-European managers, but has a bias towards country specialists, mainly in Europe; it has no bias to Northern Europe, and does have exposure to Southern European countries such as Spain and Italy. “Country specialists benefit from their local language and connections, which is especially advantageous for sourcing smaller and medium sized companies” she says.
European private equity appears to have under-performed US private equity, but Wickstrom points out that, “Europe is at an earlier stage of the cycle and valuations are higher in the US. We started to see more activity in Europe in 2018, partly because valuations are lower”. Back in 2017, Veritas CIO, Niina Bergring, expressed the view that public equity valuations were high, in an interview with IPE.
Veritas does not use third party investment consultants to find its private equity managers. The process of selecting and monitoring them is done in house. It includes conference calls, videoconferences, and site visits. Wickstrom clocks up quite a lot of air miles because few private equity managers are based in Finland.
Veritas’s market-beating private equity returns have been delivered net of fees. Fees in private equity have been much stickier than in liquid investments, and the structure rather than the level of fees may matter most. “Good managers have been able to maintain fees of around 2% management and 20% performance; the total expense ratio including other expenses could be as high as 6% according to academic studies. But what is really important is alignment of interest between investors and managers” she says. Private equity managers generally only receive their performance fees after profits are realized. Therefore, Veritas naturally has a preference for ‘European-style’ carry levied on the overall fund. Where ‘US-style’ carry is levied deal-by-deal, escrow and claw-back provisions are sought to mitigate potential conflicts of interest.
Veritas generally has 15 to 20 active long-term relationships with private equity managers. One important reason for Veritas ending a relationship has been key person risk: “the key people are important, especially for smaller funds. If the key people leave, we may reconsider our investment, and staff departures are often reflected in performance”.
ESG is clearly important for institutional investors in the Nordics including in Finland, and Veritas has been a signatory of the United Nations Principles for Responsible Investment (UNPRI) since July 2012. Its public UNPRI questionnaire responses show it addresses ESG incorporation for private equity, and incorporates ESG into the manager selection, appointment and monitoring processes. This does not of course mean that managers are running dedicated ESG strategies.
“Strictly speaking, none of our private equity managers have branded themselves as ‘Impact Investing’ strategies, but they do pursue ESG objectives, which include improving corporate governance, and environmental performance. But risk-adjusted returns are always the priority” she says.
“We will continue to prioritize mid-market buyouts” she sums up.