Investors up their allocations

Over the past decade, private equity has emerged as a mainstream asset class, included in many of the world's largest institutional portfolios. Although North American investors were pioneers in making strategic allocations to private equity, institutions in other parts of the world are quickly following suit. The recently-published fifth edition of the Goldman, Sachs & Co. and Frank Russell Company Report on Alternative Investing by Tax Exempt Organizations provides some telling insight into current alternative investing practices in North America, Europe, Australia and Japan.

Private equity meets return expectations
Despite the roller-coaster nature of the equity markets over the last two years, the Report, which draws on a survey of 526 organisations carried out during the summer of 2001, shows that institutions are continuing to increase their allocations to private equity investments. While North American institutions continue to have the highest commitment to the asset class, with survey respondents reporting an average strategic allocation of 7.5 per cent of total assets in 2001 (up from 7.3 per cent in 1999), other investors are growing their strategic allocations very rapidly. In Continental Europe, the average strategic allocation reported by respondents has increased markedly from 2.8 per cent of fund assets in 1999 to 3.4 per cent in 2001. The increase in the UK has been even more pronounced, jumping from an allocation of 2.2 per cent of fund assets in 1999 to 3.7 per cent in 2001. Further growth is anticipated by survey respondents in all regions, with strategic allocations in 2003 expected to reach 4.2 per cent in the UK and 4.5 per cent in Continental Europe.

There has been much speculation as to the reasons behind this impressive increase in interest in the asset class. Certainly the extraordinary returns (realised and unrealised) reported by private equity funds in the heady days of 1999 and 2000 attracted many new investors and encouraged existing investors to increase their commitments. According to the 2001 Report, actual annualised net returns for venture capital achieved by North American survey respondents for the period 1998-2000 were more than triple those forecast earlier in the 1999 Report. What is more, over 92 per cent of North American respondents and nearly 90 per cent of European respondents said that private equity returns had either met or exceeded their expectations.

It should be pointed out that the survey, which was carried out in the second and third quarters of 2001, was completed prior to the market shock created by the events of September 11th and does not take into account the write-downs taken by private equity managers in the latter part of 2001. However, institutional investors appear to have recognised the impact of the market downturn on their private equity portfolios even before the last quarter, realised that returns were not sustainable and built some of the impending bad news into their assessment of future performance. The Report surveyed investors about their return forecasts for 2001-2003 and found that respondents were fairly reasonable in their expectations. On average, North American institutions were looking for a 15 per cent overall net return going forward. In general, this is in line with our belief at Russell that an appropriate expected return for private equity should be about 500 basis points above long-term public market returns.

Performance varies massively
Another noteworthy finding of the Report is that private equity returns vary widely amongst investors, even within the same vintage year and investment strategy (i.e. venture, LBO, mezzanine and expansion capital). The dispersion of returns in venture capital was the highest of all investment strategies surveyed, with North American respondents reporting annualised net returns from 1998-2000 as high as 258 per cent, and as low as 7 per cent. As might be expected, the dispersion of returns from LBO funds was less dramatic, but still ranged from a minimum of 2 per cent to a maximum of 82 per cent.

This enormous variance in manager performance highlights the necessity of diversifying across private equity funds and strategies. However, many institutions lack the expertise and resources to perform private equity manager selection successfully, and have opted instead to invest through fund of funds. The Report shows that these vehicles are becoming increasingly popular, particularly in Europe where survey respondents said that 19 per cent of their commitments were made through fund of funds in 2001, up from 16 per cent in 1999.

The question on many investors' lips at present is whether this is a good moment to enter or increase their exposure to alternative assets. Although we believe that it is unwise to try and time the private equity market (or indeed any other market!), there are several favourable factors at play at the moment. Volatility in the public markets is reducing valuations for private companies, offering attractive entry points for new investments. Managers are facing a more difficult fund raising environment, are more willing to negotiate terms and conditions, and more open to accepting new investors. The speculative fever of 1999-2000 is over, and private equity managers have ?gone back to basics.? We expect there to be some consolidation in the market and that the private equity business will emerge chastened, but stronger from the experience of the last two years.

Helen Steers is Managing Director, Private Equity Europe for Frank Russell Company, based in Paris.

The 2001 edition of the Goldman, Sachs & Co. and Frank Russell Company Report on Alternative Investing by Tax Exempt Organizations was published on December 19th, 2001. The full survey can be obtained from Frank Russell Company (, and from Goldman, Sachs & Co (