Why gain PE exposure without PE returns?

THE buzz about a new kind of bond issued by a Temasek Holdings-controlled fund is that it has the potential to give a wider range of investors access to the private equity space.

The bonds will indeed make it easier for smaller investors to enter the world of private equity, but they will not offer private equity-like returns, which raises the question of why invest in them at all. Investors who are unfamiliar with the intricacies of the private equity market may actually be better off buying similarly rated instruments that are more conventional.

Astrea III, a US$1.1 billion fund of private equity funds that was set up by Temasek, a Singapore government-owned investment firm, is marketing about US$500 million of bonds backed by its portfolio of 34 private equity funds to sophisticated investors.

The private equity market has traditionally been the playground of the extremely well-heeled and of the institutions, because of the risky nature of the asset class and the large minimum ticket sizes.

But Astrea III's bonds, which come in relatively bite-sized minimum investments of around US$200,000 or S$250,000, will come in different classes distinguished by seniority and tenure, such that the bloc with the shortest maturity could be safe enough to sell to accredited investors.

The safest of the bonds will be sold in a S$234 million bloc that is expected to be rated "A" and could be fully repaid in three years. This class of bonds is understood to be a test bed for what could eventually be a private equity-based bond offering for retail investors.

The rest of the bonds are progressively riskier, with another lot of potentially "A"-rated bonds with possible repayment in five years, then a class of "BBB"-rated bonds and finally an unrated bloc. Subordinate to all of that is the sponsor, which holds equity equivalent to about 55 per cent of the fund's assets.

The bonds have not been priced yet, but they should end up offering yields that are close to comparably rated fixed income instruments with similar repayment schedules. Any other yield would suggest mispricing by the market or inaccurate credit ratings. In essence, when one buys an "A" rated bond, one should get an "A"-rated yield, which is to say not that much, and nowhere close to what a direct investment in a private equity fund could potentially return.

The implication is not trivial. Many of the investors who have traditionally not been able to invest in the private equity space presumably want to do so because of the potential for better returns. But buying into the safer classes of Astrea III's bonds will not get them to that goal. In fact, since the bonds have a fixed coupon, bondholders will not even enjoy any excess cashflow that the fund receives (that goes to the equity investor, which is fair compensation for being subordinated). To get a potential return that approaches the higher rates seen by a direct investment in a private equity fund, investors will have to move into the riskier classes, but that would probably step into the kind of territory which regulators say small folks have no business dabbling in.

The question for investors will therefore be: If you are not going to get private equity-like returns, why be exposed to private equity?

It is important to remember that credit ratings, yields and structural protection are not all there is to the product. A bond may be rated "A" at the point of issuance, but the credit risk that an investor takes on after that is dependent on the assets that back the bond.

Investors must understand that, notwithstanding credit ratings and yield levels, the bonds will also expose them to the private equity market. If the private equity universe undergoes a major crisis, Astrea III's bonds may be vulnerable to default risk, just as the housing crisis in the United States triggered defaults in collateralised mortgages in the run-up to the 2007 and 2008 global financial crisis.

Investors in the bonds should therefore consider how much they understand the private equity market. What determines the ability of private equity funds to generate returns? How easy will it be over the next three years for a private equity fund to make a successful exit from its investments? How leveraged are the underlying private equity funds, and is there confidence in their ability to meet their obligations?

The lesson of the global financial crisis is that it is important for investors to understand what they are investing in, especially if they are buying complex products.

An investor who is unsure about how the gears turn in private equity might be better off looking for yield somewhere else. There are many other more conventional "A"-rated instruments in the market that might be easier for a small investor to understand.

Astrea III's bonds are an innovative product. They allow Temasek to collateralise some of its assets and to market them to a wider pool of potential investors. If the deal works out, it could provide a capital recycling model for institutions with complex or hard-to-access assets.

They are also a legitimate investment product, giving investors exposure to the cash flow of the underlying assets. As part of a diversified portfolio, the bonds offer exposure to a unique asset class.

But investors who are attracted to the potential returns of private equity may not find the access provided by the bonds to be meaningful.