HarbourVest Global Private Equity — Closing in on a successful decade

HarbourVest Global Private Equity (HVPE) is a closed-ended investment company, incorporated in Guernsey and listed (since September 2015) on the Main Market of the London Stock Exchange. HVPE was listed on Euronext Amsterdam from its inception in December 2007 until October 2016, and its shares were admitted to trading on the Specialist Funds Market of the London Stock Exchange in May 2010. HVPE’s share price is quoted in sterling, but its functional reporting currency is the US dollar and it publishes its NAV monthly in both sterling and dollar terms.

HVPE is a private equity fund of funds, which invests in a diversified portfolio of primary, secondary and co-investment funds (as well as selected direct investments) that are managed by HVPE’s investment manager HarbourVest, an independent, global private markets investment specialist, with a 35-year track record and over US$40bn of assets under management. Headquartered in Boston, US, HarbourVest also has offices in London, Hong Kong, Tokyo, Bogotá, Beijing, Toronto, Seoul and Tel Aviv, giving it broad geographical coverage. HarbourVest’s team of more than 100 investment professionals manages a range of primary, secondary and co-investment funds.

The HarbourVest funds make commitments to leading third-party fund managers across the spectrum of global private equity investment, in venture capital, growth equity and buyout strategies. HVPE’s approach gives investors access to a very broad selection of underlying companies, as outlined in Exhibit 2, which means that the potential effect of adverse events in any one company, industry or market should be minimised.

Despite its portfolio’s wide diversification, individual underlying investments can make a material contribution to HVPE’s overall performance. HVPE’s portfolio has included a number of high profile private equity backed technology companies such as Uber Technologies, Skype, Facebook and Twitter, as well as more traditional household names such as Hilton hotels and Odeon cinemas.

In November each year, HVPE’s board approves a plan for new commitments to HarbourVest funds over the subsequent 12-month period. This plan is prepared by the investment manager, with a view to optimising long-term returns for HVPE shareholders. The total commitment for the year is based on forecast cash flows and investment returns, while the allocation by fund is set with reference to strategic asset allocation targets. The commitment plan is executed so as to maximise the benefit of any early-closing fee discounts available on the selected HarbourVest funds, while also metering the pace of commitments in line with a set of agreed balance sheet ratios.

The strategic asset allocation is defined as a set of rolling five-year portfolio construction targets by investment stage, geography, and strategy, as a proportion of NAV. The strategic allocation takes into account macroeconomic and geopolitical factors, the available opportunity set, historical performance and HarbourVest’s specific areas of expertise. The targets are reviewed annually by the board and the following revisions were made in November 2016:

HVPE maintains a consistent rate of investment, which ensures a broad spread of vintages. The fund-of-funds structure enhances this averaging effect, with commitments made by HVPE to HarbourVest funds, which are allocated over a period of three to four years to third-party managers, who invest in operating companies over the following three to five years.

HarbourVest undertakes considerable due diligence before investing in underlying managers, backed up by the long experience and extensive networks of its investment professionals. In the primary segment (where investments are into a ‘blind pool’), commitments are made to underlying funds at formation, and the HarbourVest team will focus on assessing such factors as the investment skills, leadership and performance record of the fund manager, the attractiveness of the fund’s investment focus and strategy, and contractual terms and features such as fund size, expected duration, exposure limits and fees.

Where investments are made in secondary assets (whole or part portfolios of maturing private equity investments), the managers value the operating companies in the portfolio on a bottom-up basis, projecting future performance and assessing the capabilities of the underlying fund manager. HarbourVest has experience in complex secondary market transactions, as illustrated by the Absolute and Conversus acquisitions in 2011 and 2012, where HarbourVest was able to offer liquidity to existing investors who sought an exit. The transactions were particularly complex because they involved taking private two listed private equity funds.

Direct investments in private companies – usually co-investments alongside the general partners who run the underlying funds – typically arise as a result of HarbourVest’s strong and deep relationships with leading private equity investors. The team reviews about 100 such opportunities each year, assisted by a proprietary database covering 20 years of transactions.

HVPE’s broadly diversified portfolio comprised 38 HarbourVest funds and two direct co-investments at end-January 2017, giving exposure to over 800 underlying funds and partnerships, which are invested in over 7,000 operating companies (see Exhibit 2). There were seven companies representing 1.0% or more of the portfolio (see Exhibit 1), with the top 10 underlying investments accounting for 11.8% of the portfolio and 10.4% of NAV (11.9% of NAV was held in cash). Exhibit 4 highlights that, while the top 10 HarbourVest funds account for over 60% of HVPE’s portfolio, there is a clear diversification by phase, vintage, stage, region and strategy.

HVPE aims to balance the investment phases to help smooth out the often uneven nature of private equity returns. The investment phase is when capital is drawn down by underlying managers to build their portfolios; the growth phase is the bulk of the life of the underlying investment; and the mature phase is when portfolio companies are prepared for sale and realisations are achieved through trade sales, sales to other financial investors, or companies becoming publicly listed. Mature funds include vintage years pre-2007, growth 2008 to 2012, and investment 2013 to 2017.

Exhibit 5 shows the split of the portfolio by stage, phase, geography, strategy and industry. Compared with a year earlier, the most significant change is a 15pp decline in growth phase exposure, offset by 11pp and 4pp increases in investment and mature phase exposures. This reflects the natural maturing of the portfolio, with investments moving from the growth to mature phase and mature investments being realised, leading to an increase in new investments as realisation proceeds are reinvested.

The next largest shift in exposure is a 6pp increase in the direct strategy, with 3pp corresponding declines in primary and secondary strategies. This shift largely reflects the outperformance of direct co-investments over the last 12 months, which was helped by strong gains from Lightower Fiber Networks, Capsugel (sale announced to Lonza), Leaseplan, and H-Line Shipping, and from accretive exits from The Sun Products and Planview. Direct and secondary investments are 10pp and 5pp above their strategic allocations and the exposures are expected to reduce gradually towards their target levels over the medium term, as investments are realised and HVPE’s new investments are geared towards the primary strategy.

Geographic exposure is unchanged compared with a year earlier. While the portfolio is global, it retains a US bias and exposure to the US is likely to move up from the current 62% towards the recently increased 65% strategic asset allocation level over the next couple of years. Exposures to other regions are nearer to their strategic allocations, with Europe already close to its recently reduced 18% target level.

With regards to stage, there has been a 4pp increase in mezzanine and real assets, although this remains the smallest exposure at 8%. This increase is offset by small declines in both buyout and venture and growth equity, with buyout investments still representing over 60% of the portfolio. Venture capital is a highly competitive area where HarbourVest’s longstanding relationships with the top managers are key to securing allocations in new funds. Venture capital is skewed towards technology/telecoms, which was the second-largest industry weighting at end-June 2017, as well as to medical/biotech, which is the smallest of the four industry weightings in HVPE’s portfolio.

During FY17, HVPE committed a total of US$425m to six newly formed HarbourVest funds:

During FY17, HVPE invested US$270m through capital calls to fund underlying investments (US$176m to primary funds, US$32m to secondary funds and US$62m to co-investment funds), and received US$251m from realisations (US$149m from primary funds, US$36m from secondary funds, US$23m from co-investment funds and US$43m from secondary co-investments).

Since the FY17 year-end, HVPE has committed US$137m to two new HarbourVest funds and the acquisition of a portfolio of seven venture capital funds, alongside other HarbourVest funds:

Cash drawn down by HarbourVest funds during the first five months of FY18 totalled US$107m, and HVPE received realisations of US$120m. The run-rate of new capital commitments so far in FY18 is appreciably lower than that of FY17, but the pace of investments and realisations is broadly similar to FY17. While the lower rate of commitments may represent a short-term variation in the timing of new HarbourVest fund launches, if sustained it would feed through to a lower level of cash investments in the future as the funds are drawn down by underlying managers.

HVPE principally invests through funds of funds, making its cash drawdown profile relatively predictable, with primary fund drawdowns typically spread over five to seven years. The investment manager has prepared cash flow models covering several different macroeconomic scenarios, all of which predict that HVPE’s balance sheet remains sound even in the event of a downturn worse than the 2008 global financial crisis. Although in most foreseeable circumstances the forecast level of borrowing remains very modest, the board has chosen to maintain US$500m of secured and committed bank facilities, believing that they provide an essential foundation for future investment performance by allowing HVPE to run a commitment ratio materially higher than many of its peers.

HVPE has a large asset portfolio that has historically delivered a steady flow of realisations. Since its inception, HVPE’s investments in HarbourVest funds have been funded almost entirely from current-year realisations, and its total debt remained low even during the 2008 financial crisis.

The level of HVPE’s investments (when underlying funds draw down cash to invest in operating companies) and realisations (when assets are divested) broadly correspond to the proportion of funds in investment and mature phases. Capital allocation, through making commitments to new HarbourVest funds at launch, aims to match realisation proceeds with capital calls for investments, to ensure efficient deployment of capital. Exhibit 8 (left-hand chart) shows the evolution of these three areas over HVPE’s last seven financial years. In line with the fund’s aim of achieving balance, on average the level of commitments, investments and realisations has been broadly equal.

Three key ratios are used to assess HVPE’s commitment levels:

HVPE also considers alternative measures of commitment coverage based on its capital commitments that have been allocated to third-party funds as well as HarbourVest secondary and direct funds. The commitment level shown in Exhibit 8 (right-hand chart) is calculated by taking the value of HVPE’s investment portfolio and allocated commitments, and dividing this by NAV. The coverage ratio shown reflects the sum of cash and available credit, divided by allocated investment commitments. The allocated commitment level and coverage ratio have both been stable, at c 150% and c 75%, respectively, since August 2016. Both measures stood at 126% at end-2015 and the subsequent relatively sharp move reflected an increase in HVPE’s allocated commitments. This followed a rise in the overall level of HVPE’s commitments during 2015, driven by the medium-term aim to increase to c 50% the proportion of its assets in the growth phase, which typically runs from five to nine years after initial commitment.

HVPE’s investments are principally denominated in US dollars and this remains the company’s functional currency, although the shares are LSE-listed, with the share price quoted in sterling, and NAV is reported in US dollars and sterling. In US dollar terms, HVPE’s NAV total return was 10.3% in its financial year to end-January 2017, which is higher than the 8.1% return recorded in both of the prior two financial years and in line with the 10.2% pa five-year NAV total return. Exhibit 9 shows HVPE’s NAV per share progression in US dollar terms in FY17, highlighting that underlying investment performance was the key driver of returns.

As illustrated in Exhibit 10, HVPE’s share price total return has outperformed its global listed equity benchmark over one year to end-June 2017, while its NAV total return has lagged the benchmark. This weak relative NAV performance largely reflects the lower volatility of HVPE’s returns and the sustained recovery of global equity markets after the market weakness that persisted through the second half of 2015 and early 2016. As shown in Exhibit 11, in sterling terms HVPE’s NAV total return to end-June 2017 is ahead of its benchmark over three years and the 9.6 years since its inception in December 2007, but lower than the benchmark over one and five years. The contrasting relative performance over different time periods largely reflects the volatility of global equity markets against the relatively steady progression of HVPE’s NAV. HVPE’s share price discount to NAV has narrowed by c 15 percentage points over the year to end-June 2017, and the share price strength over one year has helped to bring HVPE’s share price total return ahead of its benchmark over all periods shown.

HVPE uses a global listed equity market index (MSCI AC World Index up to 30 November 2016 and FTSE All-World Index thereafter) as an official performance benchmark, but we also compare its returns to global private equity peers, as represented by the LPX 50 Index of the largest, most liquid listed private equity funds globally. HVPE’s NAV total return has outperformed the LPX 50 Index over three and five years and since its inception, while underperforming over one year, largely reflecting a weaker relative performance over three months. HVPE’s share price total return is ahead of the LPX 50 Index over one, three and five years and since its inception.

Exhibit 12 compares HVPE’s share price and NAV performance in sterling and US dollars. Although sterling weakness was in focus during 2016 due to the sharp decline triggered by the UK’s EU referendum vote, HVPE’s managers note that sterling has been on a long-term weakening trend versus the dollar since the fund’s inception, when the exchange rate was US$2.0/£ in comparison to the current rate of US$1.3/£. This has significantly enhanced returns for sterling investors over periods of more than one year, although the short-term picture has been more mixed.

Exhibit 13 shows HVPE’s NAV performance relative to its benchmark (the MSCI AC World Index up to 30 November 2016 and FTSE All-World Index thereafter) over the past five years. Performance is compared on an equivalent currency basis and relative performance is the same in US dollar and sterling terms. For reference, we note that the MSCI AC World and FTSE All-World indices have delivered very similar performances over one, three, five and 10 years, with annualised returns differing by up to 0.1pp across these time periods. After performing broadly in line with its benchmark from mid-2012 to mid-2015, the second half of 2015 and early 2016 saw HVPE achieve notable outperformance, largely reflecting the weakness of global equity markets during this period, while HVPE’s NAV held fairly steady. Subsequent underperformance reflects the sustained recovery of global equity markets, while HVPE has delivered a comparatively strong performance in absolute terms over this period.

Similar to most listed private equity funds, HVPE has traded at a discount to NAV since the global financial crisis, although in recent years the sector discount has followed a broadly narrowing trend. As illustrated in Exhibit 14, the global private equity LPX 50 Index discount widened considerably in the second half of 2015, but this was reversed in 2016. HVPE’s discount was affected by sterling declining against the US dollar in 2016 due to its shares being sterling-denominated and its asset base being primarily US dollar-based. The currency translation effect is particularly evident on the chart between 23 and 27 June 2016, when HVPE’s discount widened from 21.7% to 33.7%, while its sterling share price declined by less than 5% and its US dollar NAV was unchanged. Although HVPE’s discount has since narrowed more sharply than the sector, its current 14.7% discount is more than 10 percentage points wider than the LPX 50 Index discount (similar to the period June 2012 to June 2014). While HVPE’s current discount is wider than its 9.6% low in May 2017, it is appreciably below its 18.8%, 19.8% and 22.7% one, three and five-year averages.

The board regularly reviews HVPE’s discount and considers options that might reduce it over the longer term. The board’s view remains that good investment performance, together with increased acceptance by the market of listed private equity as an asset class, are the key to lower discounts.

HVPE has a single share class, with 79.9m ordinary shares in issue. HVPE’s 101 voting B shares were repurchased and cancelled, and its A shares enfranchised prior to its September 2015 move to the Main Market of the London Stock Exchange. In October 2016, HVPE delisted from Euronext Amsterdam, where it had been listed since launch.

HVPE has a US$500m multi-currency revolving credit facility, which provides short-term flexibility in meeting commitments as well as underpinning its ability to meet fund commitments in the event that investments exceed realisations for a sustained period. The facility is provided by Lloyds Bank (US$300m) and Credit Suisse (US$200m) at a rate of Libor plus 300bp for borrowings up to US$250m, and Libor plus 330bp above US$250m. A commitment fee of 115bp is applied to the undrawn balance. HVPE’s original US$500m facility with Lloyds had been reduced to US$300m in October 2014 but was amended to include Credit Suisse as an additional lender in September 2015. In December 2016, the maturity of the debt facility was extended to December 2020. At 30 June 2017, no debt was drawn and HVPE had cash of US$185.2m (compared with US$175.2m at end-FY17), held in AAA-rated money market funds and equating to 12.1% of net assets.

As one of the largest investors into the HarbourVest platform, HVPE typically benefits from the lowest available fee rates on its new fund commitments to the HarbourVest funds. For FY17, total management fees represented 1.08% of net assets. HarbourVest funds pay fees to the underlying third-party managers, but these are deducted from returns at the underlying fund level rather than being separately reported. HVPE’s recurring operating expenses totalled 0.65% of net assets for FY17, while carried interest payments (performance fees) on the HarbourVest secondary and direct co-investment funds, as well as its two direct co-investments, amounted to 0.51% of net assets. No performance fee is charged by HVPE itself. Net of interest income (0.07% of net assets), HVPE’s total expense ratio was 2.17% for FY17, marginally lower than the 2.19% reported for FY16.

HVPE has not paid a dividend since its launch, reflecting the capital nature of private equity returns. Two US$20m special distributions were made following the realisation of direct co-investments in Absolute and Conversus, representing 50% of the profits on these transactions. These were implemented via the redemption of a proportion of HVPE’s A shares in October 2013 and 2014.

Exhibit 15 shows a comparison of HVPE with seven other private equity investment companies that have a fund-of-funds structure, selected from the AIC Private Equity sector (a diverse group of 23 investment companies). 2016 was another good year for the private equity industry, with a supportive economic backdrop and expanding multiples supporting NAV growth and strong exit uplifts, although total realisations were down on record 2014/15 levels. This has resulted in positive total returns for every member of the peer group over all periods shown, including from HVPE’s inception date in December 2007, shortly before the global financial crisis.

In sterling terms, HVPE’s NAV total returns are marginally below the peer group average over one year and ahead of the average over three and five years and since its inception, ranking first over five years and since inception. Although HVPE’s discount has narrowed by c 15 percentage points over the last year, a similar trend has occurred across the listed PE sector and HVPE’s discount remains wider than the peer group average. HVPE does not pay a dividend, preferring to reinvest realisation proceeds in line with its capital growth mandate, and it holds net cash commensurate with its substantial pipeline of investment commitments. HVPE’s ongoing charges are among the highest in the peer group, which may be a reflection of its ‘fund of fund of funds’ structure, although not all the figures may be comparable as fee disclosure varies across underlying third-party managed funds. Excluding performance fees on the HarbourVest secondary and co-investment funds and on its two direct co-investments, HVPE’s ongoing charges were 1.66% in FY17.

Following the appointment to the board of Francesca Barnes in April 2017, HVPE has eight directors, six of whom are independent. Chairman Sir Michael Bunbury has served on the board since October 2007, shortly before HVPE’s launch in December 2007, as have Andrew Moore, Jean-Bernard Schmidt, Keith Corbin and Brooks Zug. Alan Hodson and Peter Wilson were appointed in April and May 2013, respectively. Brooks Zug, a founder and senior managing director of HarbourVest, and Peter Wilson, a member of HarbourVest’s executive management committee who co-leads secondary investment activity in Europe, are deemed non-independent. Francesca Barnes has extensive private equity experience, most recently as a director of Electra Private Equity, and spent 16 years at UBS, serving as global head of private equity for the last seven years. The other directors have backgrounds in financial services, investment management and private equity. While it is unusual for a London-listed closed-end fund to have as many as two non-independent directors, the board is committed to having a majority of independent directors, from whom the chairman is drawn. A number of directors have served for nine years and the chairman has indicated that further new appointments to the board should be expected in due course.