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Heed the warning signs

The private equity market is showing clear signals that it is reaching the end of a multi-year growth cycle. Yet, surveys show investors are intent to increase allocations. According to the same surveys, investors claim to be aware of such signals, yet they feel positive towards the asset class.

Although seemingly illogical, this is nothing new in financial markets. It is simply hard to exit a market that has delivered returns consistently over a relatively long period of time. In these circumstances, it may be sensible to maintain or increase the allocation to private equity.

Prices have reached record highs, and a huge amount of capital (over $900bn) is yet to be deployed by private equity managers. However, most other markets suffer from similar issues – high valuations, capital chasing deals and cheap borrowing rates.

On the leverage front, the private equity market is stronger than before the crisis, with more equity invested in deals and better interest coverage for investee companies.

Provided that they maintain enough liquidity in portfolios, investors are almost compelled to shift assets from public to private equity. They have been handsomely rewarded over the past few years, with many identifying private assets as their main engine of returns.

Nevertheless, it is impossible not to notice the paradox. A recent survey of 540 institutional investors by Preqin, a provider of data on alternative assets, highlighted that 86% of respondents identifed valuations as a key concern. Valuations, and the all-time record figure for ‘dry powder’, should be enough to make any investor reconsider their allocations. From that perspective, is hard to reconcile investors’ behaviour with their perception of reality.

The difficulty with private equity has to do with liquidity. The illiquid long-term nature of the asset class means timing the market works even less than with other asset classes. The best investments may be those made near the peak of the market, as they take longer to mature. However, precisely because of that lack of liquidity, it will take much longer to repair a damaged portfolio, which might not be the case with other more liquid asset classes.

Investors should simply not be lured by the promise of higher returns, particularly if they cannot bear the risk. Much like private debt, private equity has enjoyed a surge in interest and commitment, but not necessarily for the right reasons. Investors may be using these asset classes as a refuge from potential trouble in more liquid markets. Unless they can demonstrate the skills and structure to endure trouble in these markets as well, they should heed the warning signs now.

Carlo Svaluto Moreolo, Senior Staff Writer
carlo.svaluto@ipe.com

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