Investors shrug off falling returns

Private equity investors on both sides of the Atlantic have lowered their return expectations – but allocations are set to increase.

Having begun to see the effects of the technology crash and the drying up of routes to liquidity, investors in private equity funds are increasingly pessimistic about returns.

The sixth ‘Global Report on Alternative Investing by Institutions’ – a survey compiled by Goldman Sachs International and Russell Investment Group – found US institutional investors forecasting a 12 per cent median annual return from private equity by 2005, while their European counterparts anticipate 11 per cent. This compares with the 15 per cent net return achieved by both North American and European private equity in the ten years to 2002.

However, private equity remains the best-performing alternative asset of those covered by the survey. Hedge funds returned seven per cent in North America and 13 per cent in Europe in the five years to 2002, and are forecast to return 10 per cent and seven per cent respectively by 2005. Real estate delivered nine per cent in North America and 10 per cent in Europe in the ten years to 2002, and is expected to return nine per cent and seven per cent respectively by 2005.

In absolute terms, the total commitment by institutions to North American private equity has fallen from $220bn in 2001 to $179bn, while the European total has also declined from E26.7bn to E13.9bn. Hal Strong, managing director of Russell Investment Group, said this partly reflected declining portfolio valuations and also a small drop in the percentage allocation of public funds which equates to a large numerical amount because of their huge scale.

Despite declining returns, North American institutions plan to increase their strategic allocation to private equity to 8.1 per cent in 2005 from 7.5 per cent at present (the figure was also 7.5 per cent in 2001). European institutions increased their allocation from 3.6 per cent in 2001 to 4.0 per cent in 2003, and expect a further increase to 4.5 per cent in 2005.

The UK saw a fall in allocation from 3.7 per cent to 3.6 per cent between 2001 and 2003, but an increase to 4.2 per cent is predicted for 2005. Continental European allocation was only 3.4 per cent in 2001, but has climbed to 4.2 per cent in 2003 and is forecast to reach 4.8 per cent by 2005. “As return expectations have come down, institutional investors are looking for assets that can provide a premium over listed equities,” said Nigel O’Sullivan, managing director of Goldman’s European Pension & Insurance Strategy Group.

The survey showed a huge increase in the use of fund-of-funds as a way of accessing private equity in Europe. In 1999, 80 per cent of institutional capital went into single fund partnerships and 16 per cent into fund-of-funds. In 2003, the amount going into single funds has fallen to 53 per cent, while the fund-of-funds allocation has shot up to 41 per cent. The trend is less pronounced in North America, where single fund allocation has fallen from 94 per cent in 1997 to 79 per cent in 2003 and funds-of-funds allocation has increased over the same period from two per cent to 11 per cent.

Said Patrick Cunningham of Goldman Sachs: “Our experience is that investors use fund-of-funds for exploratory access. In Europe in particular, many investors lack the resources to go out and see lots of individual managers, which is very resource-intensive.”

The report, which has been published biennially since 1992, received responses from 166 institutions in North America, 71 in Europe and 49 in Japan. The respondents comprised some of the largest pension funds, foundations and endowments.