Why are some LPs still cautious about private equity?

The asset class is an increasingly common component of investment portfolios, but some major potential investors won't take the plunge.

Alternative asset classes, once seen as niche, are entering the mainstream. Total private assets under management topped $5 trillion last year, driven by almost $750 billion of fundraising, according to McKinsey. Helping this along were record levels of LP appetite for private equity. For investors assessing the balance of their portfolios as a whole, the promise of superior returns is grabbing their attention.

“Even the median manager in private strategies is delivering a better return than the best manager in long-only equity,” says Andrea Auerbach, head of global private investment research at advisor Cambridge Associates, noting that median return of private equity is 11 percent net of fees. “The upside potential is enormous.”

“We expect in the long run to harvest about 300 basis points above our public equity returns from private equity,” says Vince Smith, chief investment officer at New Mexico State Investment Council, with $23.5 billion of assets under management and a 12 percent private equity allocation target. “That’s substantial now. Our forecast for US equities going forward is about 7 percent returns.”

In a historically low-interest-rate environment with volatile stock markets, private equity is also perceived to be more stable than publicly traded assets. “It’s one of the few asset classes that could exploit the opportunity created by the volatility,” says David Fann, chief executive at private asset advisor TorreyCove Capital Partners. “It can do things that public companies can’t, like restructure and reposition [a company].”

However, even some of the world’s most sophisticated investors remain unconvinced by the asset class. Norway’s Government Pension Fund Global, the world’s largest sovereign wealth fund with NKr8 trillion ($1.02 trillion; €834 billion) assets under management, is not yet an investor in private equity, and that is unlikely to change soon. A government white paper published in April cited transparency issues and management fees as reasons the fund should not invest in unlisted equities beyond its existing remit.

Out of its 67 percent allocation to equities the fund holds an enormous 1.4 percent of listed companies globally.

If GPFG were to invest in private equity, size would undoubtedly be an issue. “Even some of the very large funds here in the US are struggling in the private asset space,” says Smith. “When you get north of $150 billion or so it starts getting hard to get an adequate amount of capital invested.”

In the know

As the industry continues to diversify in terms of fund size, strategy and geographic focus, the ability to pick the right manager is vital. “You need to be [invested] in the first or second quartile managers to have success with private equity,” says Fann.

But searching out top performers is not easy. Outperformance opportunities are likely to be generated by less well-known managers, Auerbach says. “The difficulty is these are private markets. Information is only disclosed to investors or potential investors. You need to avail yourself of information and put in the effort to get the reward.”

Surveying the entire landscape for the right managers requires time and resources. And while industry participants note managers have gone a long way to address transparency concerns with increasingly standardised reporting, for some investors the asset class can still seem complex.

“There’s still a segment of the [investor] population that sees private equity as something esoteric and challenging to get their heads around,” says Fann. In addition, there is often a misperception that the risks of investing in private equity are significantly higher than public markets, he says.

The illiquidity of the asset class and the associated premium may be a draw for LPs such as sovereign wealth funds with an infinite time horizon. For others, like public pension funds facing cash constraints, it is prompting a rethink of asset allocations.

“Private equity is still attractive to us, no question, but we are not keen on extremely long-dated, high-fee structures,” says Aoifinn Devitt, chief investment officer at the $2.6 billion Policemen’s Annuity and Benefit Fund of Chicago. “We need to get cash in hand.”

PABF has reduced its private equity target from 7 percent to 5 percent as it seeks to address its 5 percent annual funding shortfall. At the end of last year, the fund sold off the bulk of its private equity portfolio in six funds of funds, totalling around $100 million. It continues to hold one fund of funds it could not sell.

The pension fund has earmarked allocations to private credit and infrastructure, where Devitt expects returns to be higher. “We are more in favour of investments with less of a J-curve. We like to see our cash back sooner. We particularly like private credit, which has a high cash component. Equally with secondaries, we would see some return sooner there,” she says.

Counting the cost

Private credit is one of the fastest growing investment segments among TorreyCove’s clients. It offers higher returns than fixed income and higher liquidity but lower risk than private equity, as well as a strong current income component and an ability to insulate against rising interest rates, says Fann.

An additional incentive for LPs to shift focus is the willingness of some private credit fund managers to negotiate on terms, including charging fees on only invested capital and reducing fees once the investment period is over. “Private equity has not modified its fee structure, while private credit has. That gives us more scope for fee breaks,” says Devitt.

The management fee model “has not kept pace with the expansion of the industry”, agrees Smith, who would like to see this change. “Two-and-20 on a $200 million fund raised in the 1980s is one thing; 1.5-and-20 on a $10 billion fund raised today is another. Fees including carry have become somewhat unaligned with costs. GP economics have gained significantly relative to LP economics over the last 35 years.”

NMSIC is “sensitive to operational transparency” regarding its fund investments, says Smith. To that end, in April, it hired a fee validation consultant, Colmore, for the first time to scrutinise “what’s been charged and how”, says Smith.

A related concern is GPs’ use of subscription credit lines to make an investment. “We don’t fully understand what that means in terms of calculated IRRs and that ultimately feeds into carry and GP compensation,” Smith says.

But, as LPs continue on their quest for greater clarity on the allocation of fees, the cost of investing does not appear to be a deterrent. “There is still a lot of demand for private equity because there is a shortage of investment opportunities everywhere,” says Devitt. “People see it targets 12-15 percent IRR and that is incredibly attractive. There is a willingness to tolerate the illiquidity and the fees.”