Private markets now ‘required’ in the portfolio – report

They are moving into the mainstream, with investors considering them a core part of their portfolios, according to McKinsey's latest report.

The private equity industry has evolved to a point where investors see it as core to their portfolios, according to a report from McKinsey.

“Investors used to come to private equity for three main reasons: they believed in the outperformance; they believed in the relative predictability of who would win; and they believed that there was low correlation to public markets,” Bryce Klempner, a partner at McKinsey, told Private Equity International. “What brings new investors to this space now is exposure to economic growth in addition to outperformance.”

Although private equity “eased off the gas” in 2018 after years of vigorous growth, the industry has started to show more signs of maturity in areas such as the scale and accessibility of secondaries transactions, long-duration funds and the increasing use of fund leverage, according to Global Private Markets Review 2019.

Digitisation is also taking hold. Evidence of this can be found across several areas, such as using analytics for portfolio value creation, digitising due diligence and redesigning the LP client experience, McKinsey said in the report.

“More private markets firms are beginning to step back and ask themselves: ‘Is this the most efficient way for us to organise ourselves? Are we built to scale? Is there anything we can do differently?’,” Klempner said.

As a result, GPs are looking at their portfolios and saying “digital as a trend is creating so much discontinuity and change in our portfolio companies, what could it or should it be doing for us?” he added.

Co-investment is another trend showing little sign of slowing, with 65 percent of LPs surveyed by Private Equity International indicating they plan to co-invest in the next 12 months.

McKinsey, however, noted a supply challenge in the co-investment space, with “demand for PE co-investment vastly outstripping opportunities provided by GPs”.

This wild supply-demand imbalance is not the natural state of balance of financial markets, Klempner noted.

“You are already starting to see some GPs beginning more explicitly to put a price on co-investment. The GPs with greater pricing power are beginning to take advantage of it, rather than just give co-investment away as an effective discount. And that’s a trend that we fully expect to continue.”

Klemper also noted that for many LPs, the desire to participate in co-investments outpaces the pragmatic ability to do so in terms of delegation of authority, the ability to make decisions quickly and take on individual asset risk.

“LPs with a relatively small portfolio of co-investments – which is most of them – often won’t realise that they may actually lower their expected risk-adjusted returns when they invest in too small a number of individual assets because they are taking on a lot of idiosyncratic risk,” Klemper said.

Global fundraising slid by 11 percent to $778 billion last year, and while overall deal value reached a new high of $1.4 trillion, deal count plateaued. Other notable statistics last year include an 18 percent growth in global private equity net asset value, mega-funds (of more than $5 billion each) accounting for 29 percent of total fundraising, deal multiples increasing (from 10.4x in 2017 to 11.1x in 2018) and venture capital fundraising growing 13 percent year-on-year.