The main story of 2016 was that, despite a continued anaemic economic environment, private equity delivered yet another strong year of performance. Exits and their associated distributions, while slightly behind last year’s record pace, continue to be a rare bright spot in many LPs’ equity portfolios.
Another area that decidedly has moved in LPs’ favour is a growing focus on increased transparency around fees, expenses and allocations. We hope to see the trend towards improved disclosure continue to gain momentum in 2017 from this promising start. We see this as beneficial to LPs for several reasons including a better understanding of the various cashflow streams received by GPs, more clarity in how expenses are shared across different investment vehicles and an improvement in assessing the alignment of interests between the GP and their investors.
The consistent performance of the asset class over the past several years has attracted new investors and led many existing LPs to increase allocations to the sector. These, combined with the re-investment of the strong distribution streams, have resulted in a very active fundraising market. While we have seen early indications that the US fundraising market will continue to be strong in 2017, we think that 2017 will be a lighter year in Europe. Far fewer pan-European funds are coming back to the market and even the number of mid-market and small market country-specific funds is likely to be lower. Many of the pan-European funds have raised capital over the past 12 to 18 months and therefore only a small number are expected to fundraise in 2017. Likewise, many of the regional and country-specific funds have taken advantage of the excellent fundraising conditions over the past 18 months.
By far the most interesting category to watch out for is private credit, which has seen an explosion in popularity. Demand is being driven by the changing regulatory environment as well as the quest for yield to improve the performance of LPs’ long-suffering fixed income portfolios. While this has caused a massive increase in the number of opportunities for investors to evaluate, it is worth a note of caution. The challenge is finding managers with a proven track record through a full economic cycle, as most of the newer groups have yet to see a recessionary period or possess a strong understanding of the impact of various levels and forms of leverage employed in the vehicles, particularly in a downturn.
No outlook for 2017 can ignore the economic and political uncertainties induced by president-elect Trump’s win. If Trump adopts business-friendly policies and decreases the regulatory burden, as his early cabinet picks seem to indicate he is intent on doing, it may result in a return to a more normal growth economy. Alternatively, Trump could pursue raising tariffs which could lead other nations to retaliate. A global trade war has the potential to damage all economies, as happened when the US imposed duty on 20,000 imported products in 1930. Which Trump will govern? If the election campaign was indicative, both will. Over recent years, private equity managers have generated consistently good returns despite a middling economy. As private equity historically has performed well under good economic conditions, it will be interesting – barring a trade war – to see how private equity managers fare in a solid growth economy.
Our biggest concern for the year ahead is the continued increase in valuations as capital has flowed into the private equity sector. At some point, the economy will slow, and it remains to be seen if investments made at these high price levels can meet their return expectations. We attempt to manage this by advising clients to invest steadily across vintage years to ensure balanced exposure over time.