In the summer of 1997, Peter Smitham – the chairman of Schroder Ventures (now Permira) – made the groundbreaking announcement that the firm had launched Europe’s first-ever $1 billion private equity fund.
The vehicle received half of its commitments from European investors, with the remainder coming from North American institutions – drawn in by a new strategy to invest on a pan-European rather than country-specific basis. Schroder Ventures partner Charles Sherwood told The Independent that the new fund would be able to consider “large” deals, using $150 million of equity and $350 million of debt to fund transactions.
Skip forward 25 years and the landscape could not be more different. In June, Permira partnered with Hellman & Friedman to buy US software company Zendesk in a deal that valued the business at $10.2 billion. A month later, reports emerged that Permira had secured €16 billion for its new flagship fund – 16 times bigger than its 1997 landmark vehicle.
The Permira story serves as a microcosm for the entire private equity industry, which has undergone a transformational period of growth since the turn of the century.
According to Private Equity International’s latest Global Investor 100 ranking, the world’s 100 largest private equity investors allocated $1.79 trillion to the asset class in 2021 – a sum that would have been unfathomable in the early 2000s.
How much the world’s 100 biggest private equity investors allocated to the asset class in 2021
Source: Private Equity International
Private pension funds, public pension funds, insurance companies, and foundations and endowments have all upped their allocations to the asset class in recent years, with the average private equity allocation across all LP types climbing from 8.41 percent in 2017 to 11.16 percent as of 30 June 2022, per PEI data.
“When I started working in the industry in the early 2000s, it was really a very small niche asset class,” says Dan Aylott, head of European private investments at Cambridge Associates. “But over time, it’s become more mainstream and a much more important and prominent part of investor portfolios. Over time, investors have seen the benefit of having allocations to private markets in their portfolios from a performance perspective and also in some cases from a cash generation perspective when portfolios mature.”
The shifts in the geographical make-up of the private equity investor base have been similarly striking. Firms raising funds 20 years ago would have sought the bulk of their capital almost exclusively from North American and European institutions, but as private equity’s appeal has grown, so has its international reach. North America may still account for the lion’s share of allocations, but four of the 10 largest private equity programmes now run out of the Middle East and Asia. The Asia-Pacific and Middle East now also have almost as many LPs ranked in the PEI Global Investor 100 as Western Europe, confirming private equity’s global status.
“When I started out in the industry, we used to get due diligence packs sent through the post in a brown envelope”
“Twenty years ago, private markets investors were predominantly based in the US alongside a small group based in Europe. Today that world has become much broader,” says senior private markets strategist Jim Strang, who was previously EMEA chairman at Hamilton Lane, and currently serves as chair of HgCapital Trust and as a non-executive director at the Business Growth Fund, besides other PE advisory roles.
“Now there are private equity programmes globally,” adds Strang. “The US and Europe have continued to develop, while regions such as the Middle East, Asia and Latin America now all actively invest. The tentacles of private markets have genuinely gone more or less everywhere.”
Returns drive expansion and sophistication
The underlying driver of private equity’s remarkable upward trajectory has been the risk-adjusted returns the asset class has delivered for investors.
According to research from Cliffwater, private equity allocations by state pension funds delivered net-of-fee annualised returns of 11 percent over the 21-year period to the end of June 2021, outperforming the 6.9 percent annualised return that would have been earned by investing in public equities. This outperformance did not come with more risk, with the annualised standard deviation returns for private equity coming in at 16.1 percent versus 17.1 percent for stocks.
Meanwhile, PEI’s annual investor survey, the LP Perspectives Study, shows that in each year from 2017, private equity either exceeded or met its benchmark for more than three-quarters of investors.
“The foundations of private markets were laid when there was a shift out of public investing into private investing in search of incremental IRR,” says Paul Buckley, managing partner at capital placement business FIRSTavenue. “It started in the US and then spread globally, and what has driven that spread has been the achievement of interesting returns, which have convinced investors.”
The increasing flow of capital into the industry in search of these returns has fuelled further momentum, supporting the formation of new managers and a broadening of the private equity product set into areas like co-investment and secondaries.
“Investors that have been in private equity for many years are graduating to products that are more bespoke to their requirements”
Adams Street Partners
“As markets develop, they tend to deepen. They deepen in terms of outstanding nominal volumes and in terms of investor participation,” Buckley says. “As the number of GPs proliferates, there is a stratification of the market by types of GP and strategy. In the early days, we did simple, lower mid-market buyout funds. Now we have micro-cap funds all the way up to mega-funds.
“Further, private credit and private infrastructure markets have developed. As the volume in the market deepens, there is a development of secondaries markets, and we now see secondaries deepening and stratifying as well, and spreading to new asset classes.”
Adapting to change
As the private equity industry has grown, the relationship between managers and investors has evolved, and GPs have had to adapt their operations to manage more ‘hands on’ fundraising processes and LP demand for more bespoke private equity exposure.
“If you go back 20 years, raising capital was a relatively simple process,” Strang says. “The pool of investors was smaller. As a GP, you didn’t have to talk to too many people and there wasn’t the same pressure to differentiate and articulate what made you great. The process was far ‘lighter touch’ and usually left to a senior partner of the fund as opposed to the dedicated IR armies that prevail today.
“Twenty years ago, the cadence of fundraising was slower and the level of interaction in the middle of a fund’s life far lower. Nowadays, I would argue that there is no such thing as ‘fundraising’, it’s a perpetual motion of interacting with LPs. The process has evolved a great deal.”
The use of technology has played a key role in this reconfiguration of investor and manager interaction, with the use of digital tools especially accelerating through lockdown periods.
“When I started out in the industry,” says Aylott, “we used to get due diligence packs sent through the post in a brown envelope. Things have moved on hugely and the use of technology platforms for sharing information between LPs and GPs has revolutionised fundraising. The ability to have conversations with GPs virtually has made the process much more efficient, providing new channels for due diligence and meeting managers.”
The LP-GP dynamic has also been reshaped by an increasingly sophisticated approach to portfolio construction from LPs. In the 2000s, private equity exposure would have predominantly been through primary buyout funds, but as the asset class has matured and investors have become more familiar with returns profiles, demand for more optionality and control over net returns has accelerated. Appetite for exposure to direct deals, co-investment, secondaries and other adjacent private markets including private debt, infrastructure and real estate has strengthened as a result, especially among experienced investors with mature programmes.
“Investors that have been in private equity for many years are graduating to products that are more bespoke to their requirements,” say Kevin O’Donnell, partner and global head of investor relations at Adams Street Partners. “Some will want to increase secondaries exposure for J-curve mitigation. Others will be focused on co-investment as a great way to access private equity at lower fees. Some will hire Adams Street to up weightings to particular stages of venture. Virtually half of the assets we now raise are customised solutions. Every investor is different.”
The next phase of PE
So where does private equity go next, and can it sustain the growth and returns it has delivered during the last two decades?
There are signs that the industry is now maturing, with PEI’s LP Perspectives Study showing a trend towards a higher proportion of investors being overallocated. In 2017, for example, only 4 percent of investors said they were overallocated to private equity, with 53 percent underallocated. In the latest LP Perspectives Study, published in December 2022, 24 percent of respondents said they were overallocated with just 31 percent underallocated.
There is also a recognition that the volatile macroeconomic environment will challenge private equity performance in the coming years. Only 25 percent of respondents to the latest study said they expect private equity to exceed its benchmark over the year ahead, down from the 53 percent who reported that private equity had beaten benchmarks over the prior 12 months.
“The tailwinds of falling interest rates and rising asset valuations have accounted for a large portion of recent attractive private equity market returns,” says Stan Miranda, founder and chairman of Partners Capital. “We are now looking at a period of higher and rising interest rates and no guaranty of multiple expansion from rising valuations related to public equity comparisons.”
Despite the current challenges facing the industry, however, the long-term outlook remains broadly positive, and there still appears to be plenty of room for private equity to grow. The asset class is also just starting to unlock opportunities among the high-net-worth individual and retail investor base, which has the potential to drive another transformational wave of growth in AUM.
“The tentacles of private markets have genuinely gone more or less everywhere”
“Private client appetite has grown substantially over the last five years,” says Jason Proctor, founder and managing director of Truffle Private Markets. “Until recently, this appeared to be considered by GPs as a ‘nice to have’ rather than a significant component of their LP base. We are now in a market where larger GPs are often creating vehicles specifically targeting private clients and are proactively selling to that channel, while others use third-party distribution platforms to reach a private client audience.”
For Adams Street’s O’Donnell, the fundamentals that have driven private equity’s performance in the past will remain at the centre of future success: “As much as the industry has evolved, good underwriting and selection remain paramount, whether you are on a primary team selecting managers or a co-investment team selecting deals.
“Economic downturns often clarify the delineation between the top and the bottom managers. But we have seen – time and time and again in private equity – that if you have a track record, the repeatability of that is pretty pronounced.”