More money, more problems

New research from Coller Capital shows that private equity investors are still keen to increase their allocations to the asset class, on the back of record returns. But with more money pouring into the asset class, concerns are growing that these returns may start to drop. PEO asked chief executive Jeremy Coller how LPs can avoid the pitfalls.

A new report shows that private equity investors are keen to pour more money into the asset class following years of market-beating returns – particularly from large buyout funds. But with competition for deals and allocations intensifying, will this wall of money create a whole new set of problems?

Chief executive Jeremy Coller

For its latest edition of the Global Private Equity Barometer, Coller Capital surveyed about 110 investors from Europe, the US and Asia-Pacific. Overall, the news for the LP community – and private equity more generally – was good. Nearly half of all investors are planning to increase their allocations to private equity – not surprising, given that 45 percent have achieved net returns of more than 16 percent per annum from the asset class. For investors in large buyout funds, more than 60 percent have beaten this benchmark.

Coller’s research also suggests that the industry’s investor base is becoming increasingly experienced. Three quarters have been investing in private equity since before 2000, so they are no strangers to the lean times. Chief executive Jeremy Coller believes this is also reflected in the predicted drop in allocations to fund of funds – the traditional access point for new entrants. He told PEO: “LPs often use funds-of-funds to gain access to areas where they do not have expertise, in order to broaden the diversity of their portfolios.  The 30 percent of investors planning decreased allocations to funds-of-funds partly reflect increasing knowledge and experience in the LP community.  But this move won’t necessarily be bad for funds-of-funds themselves – these particular LPs will doubtless be replaced by investors new to the asset class.”

Asia-Pacific LPs were also likely to remain important clients. Coller said: “Because so much of the private equity market is in the US and Europe, Asia-Pacific LPs have to invest more money outside their domestic markets in order to achieve a truly diversified portfolio.  So it’s not surprising they find gatekeepers and funds-of-funds very useful.”

But the picture was not entirely rosy. For one thing, these record sums of money being invested are making LPs uneasy – nearly 90 percent are concerned that there will be too much money chasing too few deals, which is likely to drive down returns.

There is probably a lesson here, in terms of over-stressing investment in markets close to home.

Coller on why European LPs have enjoyed lower returns

Another worrying aspect of the research was that European LPs appear to have underperformed their counterparts in the US and Asia-Pacific, with a much smaller proportion reporting returns above the 16 percent mark. Coller believes this may be because they have had too exposure to the European venture sector, where returns have not been so good in recent years – and too little exposure to the top-performing buyout funds in Asia.  “There is probably a lesson here, in terms of over-stressing investment in markets close to home, rather than pursuing the strongest possible portfolio diversified by geography.  European investors have been more exposed to European venture than US and Asian LPs.”

However, he feels the European venture is showing signs of recovery. “Confidence is higher among those who are actually invested in European venture, which suggests the sector still has an image problem in the wider LP community. However, the sector has learned a lot of lessons in recent years, so over time it should shake off its negative image.”

What LPs look for in GPs is consistent across both time and geography.

Coller

Overall, the survey is perhaps most notable for what hasn’t changed. For instance, the reasons LPs have for choosing GPs has remained pretty consistent throughout the years Coller has been running the survey: aggregate fund performance, continuity and succession, and fund terms lead the list. “What LPs look for in GPs is consistent across both time and geography,” Coller said. “The geographic consensus in particular highlights the genuinely global nature of the industry.”

Team continuity remains a significant consideration, even though in recent years GPs have started to address this thorny issue. “Continuity and succession planning have been an important issue to LPs for some years, and they have articulated this issue clearly to GPs.  For their part, GPs understand it and have responded,” Coller said.

Pricing has continued to strengthen over the last year, and LPs know this is a great time to sell.

Coller on the secondaries market

So what of Coller’s own area of the market? “It’s been a very busy time in the secondaries market.  Pricing has continued to strengthen over the last year, and LPs know this is a great time to sell.” Portfolio management is now the major reason for secondary activity, and within this, over 60 percent of LPs said their aim was to re-focus resources on top performers – just as giant US pension fund CALPERS did when it chose Coller to be its exclusive secondaries manager.

Of course, not everyone is in a position to do this, Coller points out. “Across the investor universe, there are more LPs looking to increase the number of GP their relationships than to reduce it.  But, for a few big players with large portfolios, focusing on top performers means making a smaller number of bigger bets.”

So big returns continue to drive bigger allocations – but unless LPs think global, the picture could be very different in the years to come.