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By Tim Friedman
Head of Communications & Senior Manager, Preqin


Private Equity: The Shifting Investor Dynamic

Committing to a private equity fund is not a decision that is taken lightly, with institutional investors in the asset class taking numerous considerations into account when assembling a portfolio. Private equity’s closed-end structure and long-term commitment timelines mean that not only must institutional investors carefully consider the fund managers to which they commit, but must also ensure that they are committing to managers with strategies well suited to the prevailing market conditions and possible future shifts in economic climate.

The past two years provide a dramatic demonstration of how a change in the global economic environment can affect different sectors of the private equity industry in different ways. Fig. 1 shows the annualized returns for buyout funds split by size. Clearly mega buyout funds were performing exceptionally well before the downturn struck, but were most heavily affected when conditions took a turn for the worse. There is a suggestion here is that the largest funds - using the most leverage and being more likely to engage in public to private deals – are more affected by changes in the external environment than their mid-market and smaller counterparts. The performance of 2005 -2007 vintage mega-buyouts has seen consistent recovery in recent quarters, but the big downturn in returns that hit in late 2008 has left a last impression on the institutional investor community.

Annualized Returns for Buyout Funds by Size
Fig. 1: Annualized Returns for Buyout Funds by Size

Does this mean that that the mega-buyout firms will struggle to raise capital? Blackstone’s ability to raise $15bn (or more) shows that there is still appetite for these very large funds. However, the level of support has fallen. At the top end, the very largest investors are no longer writing tickets for hundreds of millions of dollars, while at the smaller end of the scale, investors are no longer struggling to access over-subscribed offerings as they were back in 2007.

The shift in appetite can be seen in the results of our recent study of 100 leading institutional investors from around the world, conducted to ascertain where investors would be placing their capital in 2011. The results are telling – 55% of institutional investors see mid-market or small buyout funds to be presenting the best opportunities in the current market, with 52% considering investment in this area in 2011. Driven by strong returns, with a lower risk profile than the larger funds, mid-market funds are proving to be a compelling investment type in the current market.

Of course, this renewed appetite for the mid-market does not mean that raising capital in this area represents a straightforward prospect. There are 183 buyout vehicles seeking $113bn worldwide in the present market, and although investor appetite has improved in recent months, there will not be enough capital to satisfy every manager’s ambitions. A significant theme amongst investors at present is a desire to decrease the number of GP relationships held, committing more capital to the best managers and sacrificing other relationships that have not performed well. Automatic re-ups are a thing of the past as performance, fund terms, conditions and general strategy are being scrutinized more closely than ever before.

In terms of performance, this does not simply come down to performance relative to peers – investors are looking for genuine out-performance. In addition, an ability to out-perform in a variety of market conditions is also being seen as an important factor. It is no longer enough to point to strong performance in a growth environment if returns for funds raised in a contrasting environment have not performed as well. Following the recent downturn in term of returns within the asset class, investors are carefully considering the long-term nature of the asset class. Firms that found themselves over-exposed to highly leveraged deals made at the peak of the last cycle may find that themselves placed under significant scrutiny.

Terms and conditions are still an important factor in fundraising, with the balance of power remaining firmly with the investor. Headline factors such as management fees and carry remain important issues (and we expect to see a higher proportion of US firms switching to whole-fund carry from deal-by-deal structures this year), but we also will see more pressure on firms with regards to transaction fee rebates, and LPs will expect GPs to be placing meaningful levels of capital into their own offerings in order to ensure that interests are aligned.

Strategy is of course a key consideration and innovative strategies that are well-aligned to current market opportunities but with a long term outlook will continue to be compelling. It is also important to note that it will be possible for first-time fund managers to enjoy success, provided that they are able to show a good track record; firms spinning out from other entities – and we expect to see more of this in the next couple of years – will be on hand to inject new dynamism into the private equity asset class.

The recent success stories of firms such as Inflexion (raising £375mn within four months of launch), and Atlas Capital Holdings (closing nearly 50% above target on $365mn) show that for firms with strong past performance and a well-informed, strong, investor base, fundraising is indeed possible, and in quick time at, or even above, the targeted amount.

As already discussed, well-positioned mid-market firms stand to benefit from increased investment dollars, but there is another, perhaps more important dimension to consider when looking at the market in 2011: geographies.

Regional preferences for fund investments are undergoing a dramatic shift. Historically, Europe and North America have accounted for the lion’s share of the global private equity industry, but we are starting to see a significant rise in interest amongst the institutional community for exposure to funds in emerging regions. Such markets are set to account for a significant proportion of investor capital this year – Preqin’s investor survey shows that Asia is presenting the most compelling investment opportunities geographically in 2011 according to 52% of respondents (with 50% and 35% specifically name-checking China and India respectively). This is followed closely by Brazil with 28% of the vote. Investors in North America are very keen to gain access to growth markets, and the fund manager community is responding with both major offerings from established Western players, and also in the inception of new home-grown firms.

The challenge for new firms will be in ensuring that they are able to inspire confidence in potential Western backers. Well developed and professional investor relations and back office approaches will be instrumental in ensuring support. It is likely that opportunities in areas outside of North America and Europe will soon be a major constituent of investor portfolios. We expect commitments in these regions to at least match European commitments in coming years, although that’s not to say that we expect the size of the industry in this region to decline.

Looking forward to fundraising in 2011 and beyond, conditions are set to improve. 2010 saw activity in the private equity-backed buyout market recovering to reach the kind of levels not seen since the onset of the financial crisis. Q4 in particular represented a very strong quarter, with $64bn of new deals announced – the highest since Q2 2008 – and $72bn in exits – the highest quarter of all time. 2011 is already continuing on similar path, with high-profile deals such as Thomas H. Lee’s buyout of Acosta and Advent’s buyout of The Priory Group in the pipeline, and a number of high profile IPOs and other exits also slated.

The significant pick-up in activity is leading to capital now being pulled through the private equity cash cycle once again, and as a result, it will be necessary for investors to make new investments if they wish to maintain their allocations to the asset class.

Perhaps the most encouraging statistics from the Preqin Investor Outlook study relates to investors’ long term outlook for the asset class, which shows that not only do the majority of investors intend to at least maintain their exposure to private equity (96%), 37% actually expect to increase allocations in the longer term. In terms of their planned activity, 78% expect to match or exceed 2010 investment levels, with 45% expecting to commit more capital in 2011 compared with 2010. We have seen very few investors seeking to exit the asset class, while other new institutions continue to make their maiden allocations. All this is driven by the most important factor of all – long term returns. Private equity is, after all, a long term asset class, and over the long term has continued to outperform. This can be seen in terms of both horizon IRR returns which have consistently outperformed the major stock indices, and in terms of the actual returns experienced by investors in their portfolios. Preqin recently examined the performance of various asset classes within the investment portfolios of 150 pension plans according to their reported returns. Over a one, three, five and ten year period, median private equity returns outperformed the median total investment portfolio returns, with private equity being the best asset class over a one, five and ten year period (ahead of equities, fixed income, real estate and hedge funds).

Although it will be some time before we see the kind of fundraising levels we experienced in 2006 – 2008, and we are certain to see some firms failing to succeed in realising their current fundraising ambitions, investors still believe in private equity, and the long term outlook for the asset class remains positive.

About the Author

Tim Friedman

Tim Friedman
Head of Communications & Senior Manager, Preqin

Tim Friedman is the Head of Communications and a Senior Manager at Preqin. He is responsible for the firm’s communications efforts, and oversees the production of research papers and reports such as the Preqin Global Alternatives Reports and the Preqin Quarterly. He speaks at conferences on a variety of topics within the private equity space, and is regularly quoted in the financial press. As a member of the senior management team, he is also responsible for general strategic development.

Preqin is the alternative assets industry’s leading source of data and intelligence, providing extensive research and data on the entire global alternative assets industry via online subscription services, publications and bespoke data analysis. Preqin’s areas of coverage include: private equity, private real estate, infrastructure, hedge funds, cleantech and sovereign wealth funds.