Economy up, prospects down

To find evidence that economic recovery may bear little relationship to prospects for a given private equity market, look to Australia. Here, confidence in the economy is getting stronger by the day – strong enough, indeed, for interest rates to have been pushed up from 3 percent to 3.25 percent in October. Surveying the economic terrain, Australian GPs might find rather more comfort than their counterparts elsewhere in the Western world. So why does the mood appear grim? The economy is the wrong place to look for an answer to that question – the right place is the crisis facing Australia's pensions.

That crisis began with the denominator effect, which hit Australian pensions as it did pensions all over the world. To recap: Public equity portfolios took a pounding; private equity firms hesitated over write-downs and allocations were therefore overweighted; meaning no or less allocations to private equity until things moved back into equilibrium. The supposition in Australia was the same as elsewhere. Namely, once GPs were forced to acknowledge the demons in their portfolios and re-value accordingly, the re-set button could be pushed and – hey presto – private equity would be back on investors' agenda.

There's a case to be made that this was little more than a neat theory. And in Australia, a return to “business as normal” was arguably much less likely than elsewhere. One reason was the extraordinary bias to equities in Australian pensions' asset allocation strategies. Research conducted before the financial crisis by the International Monetary Fund revealed around 85 percent of pension fund assets in Australia were held in equities compared, for example, with 65 percent in the US.

This equities overload meant individual plan members saw the value of their pensions slashed over a two-year period up to the end of June 2009, with the first year delivering returns as bad as minus ten percent; and the second year, returns of minus ten percent at best and, at worst, minus 20 percent (pensions in Australia tend to be of the “accumulated fund” variety rather than defined benefit and are, therefore, directly linked to investment performance). As annual statements dropped through letterboxes, many members chose to exercise their right to switch out of “balanced” options – through which contributions are channelled into various areas of investment, including alternatives – and into “cash”.

As a result of this, the quantum amount of capital available for investment in private equity has naturally reduced. Because of the huge importance of the pensions as a source of capital for Australian GPs (the country's total pension pot is estimated by Macquarie Bank to be worth $1.2 trillion thanks to a policy of forced savings), this is a worrying development. It wouldn't be all that concerning, however, if the pensions still had the same broadly supportive attitude to private equity that they had during the boom years.

However, in the (understated?) words of a market observer, the pension funds “are thinking differently about private equity”, for three main reasons: 1) having seen the equity wiped out in a number of deals, they are much more interested in investing across the capital structure; 2) they are more sensitive to illiquidity, and less prepared to back funds that do not have a long track record of consistently returning capital to investors; and 3) large funds are perceived to have destroyed alignment of interest by eroding the signifi cance of carry. LPs are reported to be “aggressive on fund size” and highly cautious about backing funds targeting more than A$1 billion.

According to sources, LPs are also “dissolving the traditional buckets”. Fewer are thinking in terms of “local” and “global” allocations – these have dissolved into one. And what was a dedicated private equity allocation is now, in many cases, a generic allocation to illiquid investments. Les Fallick, founder and chairman of Sydney-based placement agent Principle Advisory Services, concludes: “There are fewer LPs with smaller amounts of money – and many of them are looking at other ways of pursuing alpha than private equity.”

I have learnt that around a quarter of Australian pension funds have abandoned or put on hold their private equity programmes, while another quarter are significantly restructuring their programmes. Coupled with an apparent lack of appetite from global LPs in Australian funds at the current time, the outlook for fundraising is clearly challenging – a reality that decent economic news will probably do little to alter.