Friday Letter: Buyers remorse

Despite exit fever, investor sentiment around private equity is beginning to erode in some places

In our November issue, some investors we spoke to voiced growing concerns over how GPs plan to make back the high multiples they paid for companies this year. Based on new data from NEPC released this week, it appears that US endowments and foundations also feel the same way.

“Endowments and foundations in the US continue to access private equity as a meaningful component of their investment portfolios. However, recent investor activity in private equity indicates endowments and foundations have increasing concerns regarding prospective returns, current valuations and access to top funds,” Cathy Konicki, partner and head of NEPC’s Endowment & Foundation Practice Group, said in the report.

Only 10 percent of respondents in the survey expect to see higher than expected returns on a go forward basis from private equity investments. The remaining 90 percent expect flat to lower than expected returns. Among the reasons for this view, respondents cited toppy valuations, challenging investor terms, and limited access to top quality opportunities and managers.

Looking at 2015, respondents said they planned to move away from more conservative allocations and into venture and growth equity in an effort to bolster returns. In terms of commitment levels, about half of respondents were looking at flat to slightly lower allocations.

In all, the survey doesn't paint the most positive picture for traditional pure-play buyout funds.

To be sure, this isn't conclusive evidence that private equity as a whole is about to fall out of favour with investors. To many LPs, its ability to generate returns continues to look attractive. In a recent survey of family offices conducted by PEI's Research & Analytics division in conjunction with Montana Capital Partners, due to be published later this month, some 35 percent of those polled said they were looking to increase their allocations next year. A mere 11 percent said they would decrease their exposure.

Still, in a frothy pricing environment like the prevailing one, it is reasonable to ask questions around how current vintages are likely to be faring, and we're seeing that reflected in investor sentiment. Sure, a lot of people have been able to realize big exits, but much of that has more to do with competition than skill. On the other side of that is a new pool of investors that have already paid a high price just to compete, with no guarantees that the desired performance will come through. It's all feeling a little 1999. Might the third quarter of this year turn out to be the high watermark in a shake-out that hits buyouts the way it hit venture at the start of the new millennium?

GPs will say that they can mitigate the cost of their recent acquisitions with platform builds or active risk management. Still others are placing big bets on organic growth. While it's easy to get caught up in exit fever, what we're seeing play out in asset prices is an inflection point few GPs will want to acknowledge. In the November issue, Hamilton Lane noted that they were keeping close watch over investments to make sure they were on pace to get all of those dollars back. Others are too.

For GPs who think it's been challenging to raise funds post-2008, they may be surprised to find out it gets harder. Consider explaining a less than fully successful platform play or big club deal in the next correction – at least venture investors in 1999 knew they were making a gamble on something untested. Watch this space.