BEWARE OF THE HERD

If recent rumblings in the world of asset management are anything to go by, private equity may soon be overrun by a herd of institutional investors desperately trying to boost returns. Sound scary? Frankly, it is.

The forces determining big picture trends in global asset allocation are of course extremely complex, but the reason why private equity professionals believe their popularity with the buyside could soon hit new highs boils down to one simple principle: pensions changed with preparing for rapidly aging population need better yield, and alternative assets including private equity, strike many as the best place to find it.

As a result, the world's pension funds, searching for new ways of matching their assets and liabilities on a long-term sustainable basis, are tipped to want to weigh more heavily into private equity. Investment consultants advising pension fund trustees, once notorious for their refusal to embrace alternative investment products, are said to have discovered the private equity product. Partly as a result, and as Roberto Paganoni, partner and CEO at Swiss alternative asset specialist LGT Capital Partners, told delegates at EVCA's Annual Symposium in June in Berlin: “The industry will be swamped with pension money going forward.”

Up-to-date studies of prospective asset allocations by institutional investors already reflect this. A survey sponsored in April by LGT, Adveq Management and Ergo Equity Partners for instance found that European institutions expected their allocations to the asset class to triple over the next five years. Such an increase would result in up to €130 billion of new capital pushing into the asset class.

In this light, it seems reasonable to regard relatively new entrants such as Denmark's retirement provider ATP, the Canada Pension Plan and the state pensions of New Jersey, Texas and North Carolina as frontrunners of a movement that will see other institutions, many of them with very deep pockets, following suit.

Among the potential heavyweight newcomers being bandied about in private equity cycles are the giant National Petroleum Fund of Norway and the Qatar Supreme Investment Council. There is also talk of pension managers in France and Italy taking an interest for the first time. And the thought of Japan's $400 billion government pension plan entering private equity for the first time has fundraisers' minds boggling too.

At face value, all of this may seem good news, especially after the industry has had such a tough time raising funds in recent years.

However, and this isn't a new insight by any means, more money would be a decidedly mixed blessing for this industry. Private equity is not a scalable business. Given the importance of investing with the best managers in order to achieve the desired performance, there is only so much capital that this market can absorb. Just ask a large limited partner what it's like to try to intelligently invest, say, an annual billion euros in the class. It's a big number, they'll tell you.

According to data published in June by the EVCA, 2003 was the first year since 1995 that capital deployment in Europe outstripped new funds raised. As a result, the overhang of capital has reduced to just 1.5 years' supply at current run rates, the association said. This is probably a healthy sign.

But if the optimists are right, this trend will reverse. Attendees at EVCA's Berlin event were also told that European private equity was currently half way through its best year ever in terms of cash distributions back to investors. This is ultimately why more potential investors are expected to want a piece of it – but unless they approach the market in an orderly queue, this would do more damage than good.

The danger is that today's performance will attract an abundance of capital that will drive up asset prices, erode future performance and, if disillusioned LPs turn their backs, make future fundraising even more difficult than it has been in recent years. This is why, as Paganoni told fundraisers in Berlin last month: “GPs need to stay disciplined. And we must keep the amateurs out.”

The predicted stampede might of course never happen. If public markets take another hit for example, forcing investors to deal with problems in their stock portfolios, private equity won't be a priority for investors new to alternative assets.

But if new investors do come to the fore in numbers, the industry will do well to manage their arrival carefully. Otherwise everyone will end up getting bruised.