Issuer: Princess Private Equity Holding
Issue type: Principal guaranteed convertible into private equity
Amount: $600 million
Bookrunners: ABN Amro, Deutsche Bank Take a fashionable but illiquid asset class like private equity: it is difficult for most investors to access and risky, but offers the potential for fabulous returns. Turn it into a fixed-income security so it can be bought by European investors that are unwilling or unable to dabble in equity. Finally, dress it up with a principal guarantee to make it irresistible to conservative investors who are nevertheless desperate for greater yield. The result can only be a sure-fire winner. Or can it?
The first zero-coupon bond convertible into a private-equity vehicle with principal guaranteed by a triple A rated reinsurer met with a somewhat sceptical response when it was launched last month. Perhaps the structure was just a little too esoteric for investors. Or maybe they sensed that behind almost every principal-guaranteed bond lies an overpriced option.
The $600 million deal was issued by Princess Private Equity Holding, a Guernsey-listed vehicle that will invest the proceeds in a variety of private-equity funds. After eight years the bonds, priced at par, can be converted into Princess shares. The principal of the bonds, which are being sold by ABN Amro and Deutsche Bank, is guaranteed by Swiss Re, a triple A rated reinsurer.
The deal targets European investors that would otherwise be unable or unwilling to access the private-equity market. The fact that this is a fixed-income product means that many insurance companies can buy it without breaching their investment guidelines. Sold in denominations of $1,000, the bonds may also interest retail customers.
Part of the paper has been allocated to a special purpose vehicle set up by Deutsche Bank. Deutsche will buy the dollar-denominated Princess bonds and issue euro- and Swiss franc-denominated securities backed by the bonds. That should reach those European investors that won’t or can’t hold assets in foreign currencies. A banker at Deutsche estimates that some 10% of the proceeds were raised through the euro-denominated securities, with Swiss franc-denominated paper accounting for a further 5%.
The bookrunners insist that demand for Princess has been strong and has come mainly from typical bond investors such as German and Swiss insurance companies. But at $600 million, the final size of the issue is at the lower end of initial expectations of between $500 million and $1 billion. One of the creators of the bond, however, says: “This is more than the $500 million we had been looking for and is an excellent performance for a unique structure which some people have had difficulty understanding.”
Principal-guaranteed bonds have a long, somewhat dubious history. They have often come into vogue in times of low market volatility when options can be bought cheaply, since they provide a nifty way of selling on options to investors that are not natural derivatives buyers.
Since the Princess bond pays no interest, the investor who buys a $1,000 bond is getting one of only two things: either the right to receive $1,000 after 10 years (the present value of which depends on this discount rate used), or deferred equity in the private-equity investment vehicle. The value of that equity will depend entirely on how well the proceeds of the bond are invested.
They will be administered by three private-equity advisers, the Swiss Partners Group, US firm Hamilton Lane and Invesco Private Capital. They will not invest the money directly in buy-outs and start-ups but will pick what they see as the best-performing private-equity funds and invest the money in them. Princess is therefore part of the trend towards private-equity funds of funds. Because of the difficulty investors find in getting into the best-performing funds, they are increasingly willing to trust their money to an adviser they believe to have good access to the most lucrative funds.
Swiss Re has devoted considerable effort to quantifying the likely returns of the vehicle. It has created a model based on historical private-equity returns, some of which date back to 1969. The model indicates that the expected annual return on investment is 15.9%, a reasonably impressive income compared with most fixed-income products. What’s more, there is, according to the firm’s calculations, a 97% chance that returns from the bond will be above 6% a year, an approximation of the opportunity cost of the investment if the bondholder would otherwise have invested in US treasuries.
And that return is after the investment vehicle has paid Swiss Re the premiums for the principal guarantee, which is 1.5% of the net asset value of the fund’s underlying investments every year. Samuel Scherling, a director of Swiss Re New Markets, admits that Swiss Re is making a respectable spread on the insurance policy it is underwriting. “We are able to charge a relatively high premium because of the perception of private equity as a risky asset class,” he says.
Swiss Re New Markets devotes itself to drumming up new ways to sell insurance products such as catastrophe bonds, an area in which it was a pioneer. “They get the insurance business from Princess,” says an investment banker involved in the deal. “But what is more important for them it to be seen to be doing something which is new and clever.”
The deal was the brainchild of Partners Group, a private-equity and corporate-finance boutique based in the Swiss canton of Zug, which has been working on the deal for 18 months. The partnership was founded four years ago by three ex-Goldman Sachs investment bankers and specializes in finding innovative ways to fund private-equity investments.
So the investor gets a fair chance of around 15.9% annual return on his investment (once the fund is fully invested after an estimated two years) and, if the worst comes to the worst, he gets his principal back in 10 years’ time. What could be wrong with that?
The problem is that historical data may be a poor guide to future returns from private equity. Money has been flooding into this sector in recent months, much of it lured by high returns since the recession of the late 1980s and early 1990s. Scores of new funds have been raised, many of them dedicated to funding the restructuring of corporate Europe.
But with so much money chasing buy-out opportunities, prices are being driven up. No longer are private equity funds able to buy unwanted divisions of big conglomerates for a pittance and float them a couple of years later at a much higher multiple of earnings. Today’s private-equity investors, including Princess bondholders, may find returns from the sector disappointing.
But at least those who bought the Princess issue won’t have lost everything. And at 0%, the guaranteed returns are only a few percentage points below European government bonds.
