Letter from Sydney

The GFC was only the latest example in the perpetual investment cycle of greed and fear. And as always, those LPs over-correcting by pulling back from private equity could end up losing out on standout returns, writes Quay Partners' Jake Burgess.

A wry comment was made to me the other day about the number of behavioural finance PhDs that could be written on the Global Financial Crisis (GFC). Initially I agreed, but then I thought about it and realised nothing had really changed. Throughout this whole GFC episode, and into the financial, regulatory, prudential, and governance amendments that are going to be brought about to “fix the problem”, there has been one unvarying constant: human nature and the resultant cycle of greed and fear.

And still today it continues. Even as investors strive to avoid making the same mistakes again, many appear to be doing exactly that. The pendulum has swung all the way back – as has happened many times before, the market has overcompensated, and the level of risk aversion currently exhibited by many in the investor community potentially represents a significant opportunity cost.

The private equity sector is a great case study of this. In aggregate, the 2005 to 2007 vintages are likely to be poor. By and large the industry’s LPs are not having a good time of it. Many are locked into poorly performing funds, liquidity is difficult, the asset class is expensive, and new investors particularly are wondering why they bothered committing. They have forgotten about the strength of returns from prior vintages that attracted them to the sector in the first place.

Arguably, it’s those investors who are retracting who are doing the most to perpetuate the cycle. At this juncture, investors have a choice – they can either dismiss the asset class as being too hard, too expensive etc, and leave, or, alternatively, they can maintain their allocations, but reassess the way (or with whom) they invest. There will be a small subset of GPs who will still deliver to investors’ expectations over the GFC period. The problem is that the second option is a lot harder to do in the face of opposition from boards, pressure from clients/beneficiaries, and taking into account liquidity issues. The negative voice on the investment committee or board is prevailing, and no one is prepared to challenge it.

But instead of getting despondent about this, let’s turn the argument on its head. Let’s embrace the cycle and the constancy of human psychology – these market dislocations can create significant opportunities for earning outstanding investment returns. Unfortunately right now for private equity there is a small fly in the ointment – the extent of the dry powder overhang. But this problem is not universal, and will be self-correcting as current fund investment periods expire (most will have done so by the end of 2012).

In Australia, the overhang is not too big a problem. It is quite possible that new funds raised here will be invested in one of the most lucrative vintages seen for a long time. Lack of competition means pricing is down, the world economy seems to be making a stuttering recovery, and our own economy is strong. It feels like companies bought today will be bought well and sold into a rising market.

The next few years could potentially be remembered as a great money-making opportunity. And you can almost guarantee that as the LPs that do stay committed to private equity start to make money, other LPs will seek to participate, more capital will be invested and so on until we’re back to a point somewhat similar to where we started. After all, this is a story that has been repeated in various guises throughout history.

The trick in the short term is to get at least some LPs to realise what they would be missing out on by opting out… But not too many, because nothing dries up opportunity like too much capital.

This guest commentary was first published in sister magazine PE Asia.

Jake Burgess is a partner and member of the investment committee at Sydney-based fund of funds Quay Partners.