MVision: Why investors are going big on the US

This article is sponsored by MVision

It’s been another huge year for fundraising – $177 billion raised in the first half, according to PEI data. As 2019 comes to a close, where are LPs focused?

Globally, private equity allocations stand at around 70 percent US, 20 percent Western Europe, 5-10 percent to China, and 0-3 percent to the rest of the market. And within that, investors are very orientated toward larger funds because they take the view they are a safe pair of hands. They are sensitive to volatility, rate of deployment and consistency of returns and visibility over communication they have the GP.

What’s driving this?

The US is flushed with cash. In addition to mega funds, a large amount of capital, particularly from public pensions, is allocated to emerging managers with funds of $1 billion and below. Why is this happening? Consultants advise their clients that private equity firms early in their formation are outperformers. It’s systematic and embedded in the structure of programmes in a way it’s not in other countries. When LPs look beyond the US ecosystem they face a limited choice of first time funds to invest with because there isn’t that growth. So the US private equity system keeps growing.

Come with me now to Europe, where early in the year a handful of mega funds absorbed a huge chunk of capital. That leaves very little available in general for other European funds. Unless you are a small GP targeting a specific investor group, it’s going to be hard work to raise a raise a €1 billion-€3 billion vehicle in Europe. There’s limited cash capacity and it will all just take longer

Where else is fundraising tough?

As we look toward 2020, in general, the growth of private equity in emerging and new markets is somewhat stunted. In Latin America, for example, unless GPs receive development finance institution funds – and that is constrained by volume – the absence of domestic and large international investors is constricting the growth of the GP community. In these markets, GP access to local LPs, of which there aren’t many – bar China – is constrained by currency and regulatory controls.  Asian and Western European LPs have limited capital to invest there, and the US is focused inward. GPs in newer markets have to reinvent themselves and use different structures to tap different sources of capital.

Where are new LPs emerging?

The US. There are new foundations and tech entrepreneurs setting up family offices. US public pensions are increasing their allocations. Every now and then there is a movement elsewhere and new investors appear. Japan was quite active for a couple of years. Taiwan, South Korea and China have appeared. They have all settled down now. There’s lots of upside in those markets, but their allocations to alternatives are very small.

Will the broader picture change next year?

I don’t see a big difference; 2020 is going to be dominated by large funds again. Some investors might be near their US limits and may invest more into Europe. I don’t see new markets grabbing anyone’s focus. For the little bit of money that is unallocated, Latin America will still be fairly hard, Africa and other emerging markets will be even harder. Japan might see a flurry of LP interest, but it’s small numbers.

As LPs look to put ever-greater amounts of money to work in private equity, what issues do they face?

Deployment is the biggest focus. If an LP has a 15 percent allocation to alternatives, that money has got to be deployed to meet their target return criteria. And when you are dealing with such large sums of money, it puts pressure on investors regarding fees.

For those investors that need to commit more than they are allocated or want to improve their J-curve and reduce fees, co-investment can help. Then the problem is, what is the formula for deciding which LPs gets what? And if LPs want to write large, $200 million-$300 million tickets and there are 20 of them wanting in, that’s another $4 billion of firepower at least – where’s that going to go? An LP can only put so much money with a GP before there is concentration risk. The challenge for funds is why some of the largest investors in the world have chosen to go direct. Direct investment has increased massively over the past year.

SHIFTING TALENT

As more LPs develop direct investing programmes, what’s the impact on domestic GPs?

In some markets like Canada and Australia, large direct investors have absorbed their GP community by hiring its talent from captives many years ago. From an individual partner’s perspective, you could be out raising funds every three to four years as a GP, or, working for one of the largest pools of capital in the world that is increasing in size.

From a compensation perspective, the waterfall mechanism has changed so GPs do not make money as quickly as before. A GP won’t touch capital for a very long time. A young partner in a large private equity firm is one of hundreds of staff, so why not move to a significant pension plan and join a team of 50-60 with lots of firepower? It’s a very attractive option.

 

Are LPs in a position to exercise any leverage over terms, fees or pricing?

Investors need to allocate to the best funds. Interest rates are low – negative in some countries – and they need to be able to generate returns and can only do that through alternatives and private equity specifically. Private equity is their saviour. Core funds have the upper hand. The mega funds lead the way and the LPs follow along; they don’t negotiate.

That said, all funds seek a big first close. As a result, a LP is in a position to open discussions: if I give you a $1 billion commitment at first close, I want to be treated differently from an LP that gives you $50 million. This raises an interesting question about the alignment of LP interests within a fund, but that’s how it works.

What is your view on a downturn? How are LPs geared to protect themselves?

They are dynamically using primaries, secondaries and co-investments to manage their exposure and returns and the elasticity of the J-curve. LPs are concerned about toppy-ness in the market, but the way to run a programme is not to try to time markets. LPs want to find GPs that can work their companies. Deal flow is still very healthy. A great company is a great company. GPs are less sensitive to the price on entry and more focused on what they can do operationally to generate value.

How do LPs measure operational success?

Two ways: one is the running of the management firm. That has risen to top of mind. LPs are looking very carefully at checks and balances, chief executive responsibilities, the chief financial officer’s remit, how the investment committee makes decisions, valuations, how cashflow is monitored and recorded.

All this scrutiny is generating detailed reporting. And second, LPs have always asked a lot of questions in due diligence about value creation. They want to understand how the GP will develop a three to five-year plan with the management team, and how data supporting performance metrics is compiled.