Investments in private equity are becoming a common choice among institutional investors, with allocations to the asset class increasing significantly over the last few years. According to a recent comparative study conducted by private equity firm Adveq – covering institutions across Germany, Switzerland, the Netherlands, the UK, the Nordic region and Australia – over a third of the respondents invest in private equity or they are considering doing so.
In the early-1980s, only a handful of institutional investors would dare to invest in unquoted companies, but things started changing during the 1990s as the level of sophistication among industry players greatly increased.
According to Guy Eastman, European investment director at private equity firm SVG Capital, the last decade saw investors becoming more confident about the asset class, a confidence that grew over the last few years.
“The investment returns in the asset class now are really quite strong and at the same time the quoted markets have been through a period of relatively flat performance which has encouraged a number of institutions to try and find another way of boosting returns,” Mr Eastman says.
More respectability
As the asset class becomes more ‘respectable’ and more institutions start making allocations, the challenge for the sector is to offer investors the same level of performance achieved when capital inflows were much smaller. “Now if you get a huge wall of money coming into the asset class the danger is that private equity suddenly becomes mainstream and it will be harder to produce the sort of returns people are used to,” Mr Eastman comments.
However, Adveq managing director Peter Laib believes larger inflows into the asset class will not have a major impact on some segments of the industry.
“I think the statement ‘too much money chasing too few deals’ is just too easy,” he says. For Mr Laib, the private equity sector will develop into two different segments driven by two different dynamics. “One is the venture sector in the small-cap segment which will follow a traditional philosophy in a way that you would have many managers, a selected number of deals and higher competition,” he says. In this segment the very best players are likely to significantly outperform those of lower quality.
However, he explains, in terms of volumes most of the capital moving into the asset class today is going into the large-cap market, where the idea of larger inflows having a negative impact on performance is not relevant.
“The large-cap segment will follow completely different dynamics,” Mr Laib explains. “There, the question will not be as much about the selection issues, but more about professional capabilities.”
According to data from KPMG, the vast majority of the record £24bn (e35.2bn) invested in private equity in the UK in 2005 went into largest end of the market. “Although there is more money coming in, this is pushing the boundaries of the size of private equity deals that can be done and as a result the weight of money is finding bigger homes,” says Richard Green, joint managing director at Kleinwort Capital, a private equity firm investing in UK medium-sized companies.
The good performance of the asset class in the recent past is one of the reasons for investors to allocate money to private equity. However, the Adveq study shows that performance expectations among institutions are now more realistic than they were only a couple of years ago.
Lower expectations
Return expectations across Europe are now between 10 to 12 per cent. “Two years ago people were expecting around 20 per cent, and I think this was definitely too high from a long-term point of view. But with 10 to 12 per cent we are pretty much in line with what could be considered as realistic,” Mr Laib says.
“I was curious to try and find out how institutions got to that number and the interesting finding was that typically it wasn’t an estimation of the return potential in private equity, but what they do is to take the public equity return expectation and add 300 to 500 basis points,” he says, adding that this means that private equity return expectations will always be strongly dependent on what institutions expect to get out of the public markets.
Institutional investors’ first steps into private equity follow a similar pattern across different countries. In general, people show a strong home bias. “Especially at the beginning of the development of a private equity programme you see there is a strong tendency towards their domestic region,” Mr Laib says. “Also many institutions start by making direct investments in companies. What you see across all markets is that as markets mature and institutional investors become more professional, both the home bias and the level of direct investments into companies decreases.”
Nordic and Australian investors are those showing a stronger tendency towards investments in their own region, that in both cases represents 74 per cent of total investments. On the other hand, Swiss and Dutch investors’ domestic investments in private equity only represent around 20 per cent of their total exposure to the asset class. (see figure one)
In terms of different strategies and investment vehicles being used by investors, Australian institutions have the higher exposure to direct investments into unquoted companies, representing 20 per cent of the total private equity portfolio, as opposed to the
13 per cent registered in Switzerland (see figure two).
These direct investments are mainly in the home market and are expected to decrease considerably over the next two to five years, whereas allocations into pooled funds and funds of funds, and international exposure will grow.
According to SGV’s Mr Eastman, pooled funds and funds of funds represent a very attractive route into private equity for most institutional investors.
“It all depends on the amount of money that you have to commit to the asset class, because in order to hire or build your own in-house team you would need a substantial amount of capital, more than most institutional investors have,” says Mr Eastman. “As a result it is probably more efficient to work with a team of experts who – if you choose any of the leading fund of funds groups – will be able to offer you a team that has maybe 10 years experience in private equity investments and has also access to some of the hardest funds which are becoming oversubscribed.”
Funds of funds also provide access to different regions across the world although, according to Mr Eastman, Europe still remains the most attractive region to do business.
“There is still a fair amount of restructuring going on in Europe and this remains a very attractive area,” he says. “I think one of the risks with emerging markets, the Indias and the Chinas of the world, is that quite a lot of capital is flowing into those areas but there is not a huge amount of track record on which to build your position.”
Mr Laib, on the other hand, mentions the Asian technology sector as one to seriously consider, with many attractive opportunities still to be exploited. He also shares the view that Europe still has potential in both the small-cap and large-cap segments, but notes that investing in the mid-cap sector is a bit more complicated.
“[In the mid-cap market] you might have 70 to 80 managers competing for about 100 deals where you have fully transparent markets and where you can see prices going up. I think some people are sometimes taking too much risk,” he says. “So Europe is offering good opportunities, however on an extremely selective basis.”
At Kleinwort Capital, Mr Green has his own views regarding the opportunities to be found in the mid-cap sector.
Crowded area
“It depends on what is the definition of mid- cap market because it keeps changing,” he says. “I think the most crowded area of the market is the £100m to £500m deal size where there is a huge number of players.” But as you go down into the lower mid-cap market, he says, there is a much larger number of deals and fewer competitors.
“For instance, the very big buy-out houses are pushing the boundaries of the market and the competition there is less than in the mid market,” Mr Green explains. “In the lower mid market we found that a lot of players that used to play in that space have raised bigger funds and move out of it.”
Future competition among different managers will be very much dependent on investors’ demand in the asset class. The question now is: does one wait to see whether the current appeal of private equity is less of a short-term fashion and more of a long-term investment strategy?
“It’s already been around for more than 20 years and I think it’s got very solid practitioners around it,” Mr Eastman says. “It is also becoming more and more accepted as a form of corporate finance for unquoted businesses.
“I do think that at present the asset class is very ‘fashionable’, maybe slightly more than it needs to be because it is a long-term asset class that is here to stay and right now there is a huge amount of buzz around it.”
