Dry powder and valuations to remain high in 2016

Returns on private equity investments may fall due to continued high valuations in the market, but investors will stay attracted to the asset class thanks to its outperformance over public markets.

Scott Reed, head of US private equity at Aberdeen Asset Management, explains to Private Equity International why last year’s strong distributions to limited partners will keep dry powder at its record highs and how investors seeking access to new parts of the private equity ecosystem is a natural evolution of the asset class.

Q. What are you anticipating for the private equity industry in 2016?

A. We likely set a record in 2015 with distributions, and LPs are channelling that capital back into fresh commitments. If we have a choppy period with the public markets that will only serve to temper new deal activity and cause dry powder to go up further.

If economic concerns persist, with more volatility early in the year, banks may reign in their activities on the credit side. That would likely help valuations, but you still have dry powder pressures and active strategic acquirers working the other way. So our view is that valuations are likely to stay high; maybe they won’t set new peaks but they’ll be up there. And I think the dry powder equation will get worse before it gets better. Credit conditions could go either way, depending on global economic readings and volatility in the liquid markets. Internal rates of return will probably come down, even if multiples of capital are fine. It takes a while for general partners to deploy capital and they will probably have longer holds to justify the valuations on prices paid.

Q. If IRRs are expected to decline, what is fuelling the continued interest in private equity from investors?

A. It’s all about relative performance. Private equity has consistently outperformed the public markets by 300-plus basis points. Even in the last five years when the public market enjoyed a tremendous bull market, private equity kept pace. And when the public market is choppy and volatile, you typically see outperformance [in private equity]. Maybe absolute IRRs will come down, but from an outperformance standpoint, private equity is well-positioned to do just fine versus public equities

Q. What are investors hunting for at the moment?

A. We tend to focus on managers at the smaller end of the private equity spectrum, typically fund sizes between $100 million and $500 million. We’ll consider larger managers from time to time but the sweet spot is at the lower end of the mid-market and we do invest quite actively with new managers. Many investors are looking for more specialised managers because they have the advantages of generating returns. It’s hard to do well across all sectors for GPs as the overall industry gets more competitive and more efficient. The larger managers out there will continue to be generalist in nature. But the smaller managers typically don’t have the resources and capabilities to fully invest across all sectors.

From an LP standpoint, many private equity investors are pursuing hybrid strategies: trying to establish core exposure to the asset class through brand-name funds that typically invest at the higher end of the spectrum, and then adding specialist, smaller mid-market managers to drive alpha. Their time is split between securing allocation with their core existing relationships and identifying and accessing smaller managers with potential to outperform.

Certainly, separate accounts are of increasing interest, which is a function of the maturation of the asset class. Certain LPs want tailored mandates, better economics and to stay close to the decision-making process. Other investors want to penetrate parts of the private equity ecosystem where they don’t have exposure.