LPs remain bullish on private equity

Appetite for the asset class is going strong, despite a concerning combination of high valuations and a faltering economic environment.

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The overwhelming majority of LPs expect to maintain or increase their exposure to private equity over the next 12 months, despite global shockwaves from the pandemic, according to Private Equity International’s LP Perspectives 2021 Study. Indeed, 45 percent plan to pump more money into the asset class.

This bullishness reflects solid performance. More than two-thirds of investors found their private equity investments have met or exceeded benchmarks in the last 12 months. However, returns have fallen short for more than one in five LPs, up from 8 percent a year ago. The proportion of investors to have experienced outperformance has also declined from 47 percent to 34 percent.

In a protracted low interest rate environment with limited alternatives for alpha, however, appetite for private equity remains voracious. The fact 36 percent of LPs find themselves underweight to private equity will only exacerbate this trend.

Investors in the asset class remain confident about its ability to navigate a turbulent short-term future – 39 percent believe their portfolios will exceed benchmarks in the next 12 months. Only 16 percent fear the worst. Meanwhile, 72 percent of LPs are either confident or very confident that private equity deals have been structured sensibly enough to withstand the downturn.

“Perhaps the most striking feature of private equity’s handling of the covid downturn, compared to previous economic crises since 1990, has been the speed and hands-on approach adopted by GPs to position portfolio companies for a sustained downturn,” says Peter Linthwaite, head of private equity at Royal London Asset Management.

“The drive for liquidity; renegotiating banking facilities; taking advantage of government packages and rapidly repositioning strategic plans, have all contributed to maintaining the integrity and sustainability of portfolio companies. Overall, I believe private equity will continue to generate alpha over the medium term and remain a highly attractive asset class.”

Merrick McKay, head of European private equity at Aberdeen Standard Investments, is also positive. “Private equity firms today are far removed from the passive backers of good management teams they were in the distant past,” he says. “Today, the private equity model is ideally suited to driving business growth in benign environments, but also to making the changes that need to be made when the going gets tough.”

Favoured strategies

Buyout, growth capital and distressed strategies are deemed the most attractive segments right now. LP appetite varies significantly, however, by region. While over 30 percent of investors expect to boost their exposure to Asia-Pacific, Western Europe and North America, interest in emerging and frontier markets has slumped.

LPs are watching closely to see how GPs pivot their investment strategies to respond to the current situation. While half of investors believe their managers are remaining disciplined and are sticking to their investment thesis, 47 percent have experienced occasional examples of style drift.

There are also some investors – albeit a minority – that still believe they do not have sufficient information with which to assess performance.

“There is no question that investor reporting on performance has improved significantly in the past 10 years. But comparative data remains patchy and perhaps the greatest weakness in making the case for private equity in any asset allocation decision is the lack of regularly produced and consistent PME [public market equivalent],” says Linthwaite.

“The covid crisis has highlighted the weakness of current valuation and reporting practices at times of market turbulence. At a very minimum, quarterly valuations should be required, reversing the trend towards semi-annual valuations. The issue of the lag of two months-plus between quarter ends and the production of GP reports also needs addressing.”

Of course, the macro environment is presenting plenty of cause for concern. While the US/China trade war may have slipped down the list of challenges keeping investors awake at night – from 61 percent last year to 33 percent this year – unsurprisingly, the covid-19 outbreak and anticipated recession in core markets have many LPs rattled. Interestingly, however, as we teeter on the brink economically, extreme market valuations are also perceived as among the biggest risks facing the asset class.

“Valuations would be my biggest concern,” says Paul Newsome, a partner and head of investment solutions in Unigestion’s private equity team. “Private equity can invest in sectors that will grow irrespective of covid. The problem is everyone will have the same idea and will end up chasing the same companies.”

“There is a lot of pent up demand and so we have been expecting private equity returns to slip from their heady heights for some time,” adds McKay. “Everything suggests they should continue to significantly outperform the public markets but the sheer amount of money out there in what may be a moribund economic climate could lead to a dip in performance.”

Others, meanwhile, believe the industry is at a critical juncture when it comes to maintaining its fragile reputation. “My main concern is that a few failed private equity-owned businesses will stir up a wave of public dismay and thereby bring the threat of increased regulation as well as general negative sentiment towards the asset class,” says Mikael Huldt, head of alternative investments at AFA Insurance.

“My hope is that with the current pandemic and following economic challenges, the private equity industry can prove to everyone that responsible, active ownership and asset management will be an essential part of the economic recovery as well as sustainable innovation and economic growth going forward.”