A new survey shows recovering confidence in private equity, but LPs are becoming more selective about their investments.
A spate of portfolio rebalancing is in the pipeline that will see LPs become more Asia-focused yet also more careful about to whom they commit capital, a further sign of how attitudes towards private equity have changed in the wake of the global financial crisis. Perhaps the most startling explanation for this approach – as set out in the latest Global Private Equity Barometer produced by top-tier secondaries firm Coller Capital – is that LPs expect one in five GPs to fail.
Close to 100 of the 110 institutional investors surveyed by Coller expect to turn down opportunities to participate in funds launched by GPs with whom they have worked before.
“There are a whole variety of reasons for individuals to re-balance,” Coller partner Hiro Mizuno tells AVCJ. “Many endowments and foundations, for example, found themselves overexposed to PE during the crash. And some investors see their portfolios as too skewed by vintage year or investment stage, while others want to modify their balance between developing and emerging markets.
“Most LPs with a very large PE exposure in absolute terms are now looking to tighten their portfolio focus on a smaller number of their best performing GPs.”
This should not be interpreted as a sign of waning confidence. Nearly two-thirds of survey respondents report a strong rebound in lifetime net returns of 11%-15% or higher from their private equity investments, up from just under half last year. There was, however, considerable regional variance in this finding; it applied to 71% of North American LPs, 58% of Asia-Pacific LPs and 53% of European LPs.
Also buoyed by expectations of strong exit potential via trade sales, about a quarter of respondents say they will increase private equity allocations over the next year, while 12% aim to reduce it.
Another majority (60%) claim to be satisfied that the debt component in higher quality PE deals is now appropriately proportioned relative to equity, although 20% are concerned that debt oversupply is enabling poor deals and/or leaving even some higher quality transactions over-levered. Again, regional opinions differ: those concerned about an alleged debt overhang are much more numerous in North America (29%). In Asia, 27% of those polled worry about a shortage of debt, even for good deals.
In 2008, one private equity study estimated the general debt portion in buyout deals as 60%-90%. But according to Mizuno, the current level in European and North American buyouts is at the bottom of this range. In Asia, a separate source reckons it’s only 30%-50%.
Positive sentiment notwithstanding, there will be modality shifts when GPs start fundraising again. Previously, the bigger buyout players at least could be very selective as to the investors they approached. Going forward, it seems probably that the LP mix will change, with the need to attract more of them and for smaller funds. “A large overhang of PE capital committed during the bubble means fewer investors are able to make commitments now, and those commitments will often be smaller,” Mizuno confirms.
This doesn’t amount to much of a negative for Asia-Pacific investors – only one-fifth of them said that capital constraints will lead them to refuse re-ups in the near term, compared to three-fifths of North American LPs.
It is clear that the Asia-Pacific region will receive a lot of the capital available, but within this there are interesting divergences, concerns and curiosities. LPs in Asia-Pacific commit 57% of their regional portfolios to the developed markets of Australasia, South Korea and Japan. Among North American investors, the approach is more balanced, with 53% going to the emerging markets of China and India and 42% to developed nations. European LPs, however, commit twice as much to China and India (63%) as to Australasia, South Korea and Japan (31%).
These ratios are in flux. Nearly a quarter of respondents plan to up their Australia exposure over the next two years, while 18% claim they’ll increase their exposure to South Korea. Interest in Japan, on the other hand, is starting to slip.
The issues that most concern LPs include much-sharpened competition in Australasia, and the shortage of established GPs, and private equity professionals of a certain caliber in China and Korea, augmented by weak exit potential in Japan.
Change is also apparent in the LP employment landscape. The survey found that 47% of pension funds and 41% of insurance companies are noticeably bulking up their private equity teams. Clearly this reflects a comforting confidence in the long-term prospects of the asset class. But might it also suggest they’re looking at doing more direct investing, and hence have a pressing need for greater due diligence capabilities.
“For some investors, ‘directs’ are a factor,” Mizuno says. “But for all ‘public’ investors (i.e. public pension plans, insurance companies) the demand for greater due diligence across all types of PE have increased significantly because of the divergence of returns between stronger and weaker managers during the global financial crisis.”
Another interesting finding is that while LPs have long been able to claim low turnover among key staff – 76% have worked for their present employer for five years or more – those surveyed expect that 26% of their number will change jobs over the next two years.
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