“It is difficult to overstate how much LP due diligence has evolved in recent years,” says Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association. Indeed, the private equity industry, like the wider world, has experienced an unprecedented period of change.
Not only have investors had to rapidly come to terms with a largely virtual due diligence environment, but ESG and DE&I have shot up the priority list. At the same time, structural innovation has continued unabated – evidenced in particular by an explosion in GP-led secondaries and continuation vehicles, as well as evolution in fund finance and a proliferation of opportunities to invest in management companies.
Private Equity International’s LP Perspectives 2022 Study gauges the expectations, hopes and fears of the LP community, against this complex and fast-moving backdrop.
As the longest bull run on record extends into its second decade, investors remain optimistic about the performance of their private equity portfolios. More than a third of respondents expect the asset class to outperform benchmarks, while only 8 percent believe it will fall short. Investors are more confident about private equity continuing to deliver than they are about infrastructure or private debt. Only venture capital is commanding more optimism, with a striking 40 percent of investors predicting outsized returns.
The continued impact of the pandemic, extreme market valuations and the threat of both recession and higher inflation are all cited as having the potential to affect portfolio performance over the next 12 months. Concern over the threat of inflation is particularly stark: 40 percent of investors cite it in this year’s survey, whereas only 6 percent raised it as an issue last year. “I do think that inflation is on people’s minds,” says Bart Molloy, partner at Monument Group. “I would expect inflation-hedged real asset strategies to benefit from those concerns.”
The geographical weighting of private equity allocations is poised to shift. More than a third of investors plan to boost investment across Asia-Pacific, Western Europe and North America, while 40 percent or more of the LPs surveyed intend to reduce investment in the Middle East, Africa and Latin America. “Interest in North America continues to be steady and we selectively see investors playing offence in Northern Europe,” says Malloy. “Sentiment on Asia tends to be more mixed, given macro issues related to China.”
A solid 74 percent of LPs believe that a strong ESG policy will lead to better long-term returns in their private markets portfolios. “There is a growing consensus amongst investors that a strong ESG approach is a key part of risk management and value creation,” says Ali Floyd, senior vice-president at Campbell Lutyens.
“When I first joined the Church Commissioners, we were often pushing on a closed door, particularly outside Europe,” says the group’s head of alternative strategies, Roy Kuo. “But over the past two to three years, the industry has done a 180 on these issues.”
Beyond its track record, a GP’s team size and investment capacity are deemed to be the most important elements of due diligence, followed by a terms and fees benchmark. Meanwhile, the proportion of investors that consider ESG to be critical to the due diligence process has increased dramatically, from 38 percent in last year’s survey to 57 percent this year. However, while diversity, equity and inclusion at the GP level form a component of most investors’ due diligence, fewer than a third of respondents place significant emphasis on DE&I and 15 percent of investors do not consider it at all.
Some 15 percent of LPs expect to only be active sellers of private equity interests in the secondaries market over the next 12 months. This is despite secondaries buyers predicting a resurgence in the sale of LP stakes as they seek to rebalance their portfolios after an intense period of highly concentrated GP-led deals.
However, 28 percent of investors do expect to be active as buyers only, as LPs increasingly use the secondaries market to help them reach climbing allocation targets and to proactively manage their geographical and sectoral exposures. Meanwhile, the proportion of LPs that plan to both buy and sell fund stakes on the secondaries market has fallen from 20 percent in last year’s survey to single digits.
GP stakes ambivalence
More than a third of survey respondents say they would like to commit to GP stakes funds or have already done so, drawn by the predictable, contracted management fee revenue that such investments offer. The majority of respondents remain unconvinced, however, with commonly cited concerns including a lack of predictable exits and the inherent conflicts of interest that come from LPs being exposed to multiple funds and management companies.