Halcyon days for PE, but macro concerns mount

Appetite for the asset class continues to rise at a staggering rate, but there are lingering concerns over what might happen when the music stops.

As this year’s heady fundraising environment shows, investor appetite for private equity is only getting larger. Private equity funds raised around $535.3 billion in the first nine months of this year, the highest fundraising total for this period since the global financial crisis, per Private Equity International data.

Some 93 percent of investors intend to invest more or the same amount of capital in private equity over the next 12 months, according to PEI’s LP Perspectives 2022 Study. Texas Municipal Retirement System is among those turbo-charging its private equity exposure. The Austin-based pension, which has $2.4 billion in private equity assets under management, wants to increase its allocation from 3.97 percent at the end of 2020 to 10 percent by 2024, according to an October board meeting.

“The goal is to enhance the trust fund’s performance, and given the returns, there is a huge opportunity set in PE,” said director of private equity Tom Masthay at the meeting, noting that the system’s private equity portfolio has returned 27 percent since inception in December 2015. Public equities returned 13 percent over the same period.

“Because most companies are privately owned, as less than 1 percent of US firms are publicly traded and 86 percent [of] firms with 500 or more employees are privately owned,” Masthay said. “The smaller the companies, the more value you can add.”

Abu Dhabi Investment Authority has also increased its appetite. The sovereign wealth fund – which manages an estimated $649 billion, according to the Sovereign Wealth Fund Institute – raised its allocation band from 2 percent to 8 percent in 2019 to 5 percent to 10 percent last year, according to its annual report in September.

Exceeding expectations

Performance seems to be a key driver of investor demand, with 36 percent expecting the asset class to exceed its benchmark over the next year. Only 8 percent believe it will fall short. The overwhelming majority (95 percent) say private equity met or exceeded its benchmark over the past 12 months.

Massachusetts Pension Reserves Investment Management Board is among those reaping the rewards. Private equity was the pension’s highest-performing asset class last year. Gross of fees, private equity returns as of the end of 2020 were 26.4 percent over one year, 21 percent over three years, 20.2 percent over five years and 19.1 percent over 10 years. Unsurprisingly, the pension fund voted in February to raise its private equity allocation from between 10 percent and 16 percent to between 11 percent and 17 percent.

Rampant fundraising activity appears to have helped investors to achieve their private equity ambitions. About a quarter (24 percent) of LPs surveyed believe they are under-allocated to the asset class this year, down from 39 percent last year. Los Angeles City Employees’ Retirement System is one such investor: in May, the scheme hiked its allocation target from 14 percent to 16 percent. Its actual allocation was 12.7 percent.

Growth capital and buyouts look set to benefit from rising demand, with more than three quarters of investors planning to maintain or shift more capital towards these strategies over the next 12 months. Growth, in particular, has enjoyed a strong year: Blackstone and EQT are among those that have launched a fund dedicated to the strategy in recent years.

“Investors are attracted to growth funds because they usually clean the cap table – enabling a lot of venture firms and investors from different rounds to exit, resulting in an easier-to-understand shareholding structure,” Jean-François Le Ruyet, a partner at Paris-based fund of funds Quilvest Capital Partners, told PEI in March.

Still, the picture is not as rosy for all corners of the private markets. Around 40 percent or more investors expect to have less interest in investments focused on the Middle East, Africa and Latin America in the next 12 months, perhaps reflecting a market-wide shift towards larger funds managed by more established brand-name GPs during the pandemic.

Inflation fears

What’s more, these halcyon days for private equity could be numbered. Some 40 percent of respondents now believe inflation could greatly impact investment performance. Last year, that figure stood at just 6 percent.

Earlier this year, Blackstone’s chief operating officer, Jon Gray, identified the issue as a “major risk”, noting that the firm would respond by targeting businesses with “real tailwinds” whose growth can offset the pressure placed by higher inflation on multiple expansion.

Rising inflation could have implications for interest rates, which, in turn, may have significant repercussions for the asset class.

“For those for whom it’s been the best of times, eventually something will end,” Carlyle Group co-founder David Rubenstein told TechCrunch in September. “At some point, the Federal Reserve will increase interest rates… [and] people begin to say, ‘I’m taking more of my chips off the table. I’m not going to invest as much at these valuations.’”