The largest of these global institutions are estimated to have total assets of around US$4 trillion. If we assume that an average 2% is allocated to private equity by 2015, that is $80 billion seeking PE assets in the next three or four years. This works out to about US$20 billion annually, which is not excessive by total historical flows of about US$250 billion annually.
However, the more pertinent question for asset owners is, will there be enough top quartile PE managers? The likely answer is no. These institutions will be competing with all the other investors looking for the best PE managers. Consider that total annual fundraising is US$250 billion (from all investors, not just the premier institutions); one quarter is US$62.5 billion. In other words, top quartile capacity accounts for only 1.6% of the top institutions’ US$4 trillion in assets in any vintage year. According to Preqin, an alternatives research firm, the 10 largest PE firms worldwide manage on average about US$43 billion each, and these may not all be in the top quartile according to performance.
“Managers below top quartile usually can’t deliver returns that are commensurate with the fee structure and liquidity risk associated with PE,” remarks Joshua Kahn, director of Hamilton Lane, based in Hong Kong. Hamilton Lane directs about US$120 billion into PE assets on behalf of investors worldwide, including pensions and sovereign entities.
Research conducted separately by the business school INSEAD and by Preqin show a significant performance gap between top-quartile and bottom-quartile PE managers. INSEAD’s study is on Asian PE, while the Preqin study includes worldwide PE.
The study by INSEAD’s Global Private Equity Initiative included 30 of the largest limited partners with assets allocated to Asian PE, including sovereign funds, pension funds, family offices and funds of funds with a total US$9.4 billion in commitments to the region. The study found that the internal rate of return (IRR) differential between upper quartile and lower quartile managers was 16% from 1994 to 2008.
Preqin’s study of 2,500 buyout and venture capital funds worldwide analyzed their quartile rankings during the fourth year, sixth year and at maturity. The study concluded that half of buyouts that make it to top quartile at year four remain there until maturity and 75% exceed the median. If the top-quartile buyout maintains its position up to year six, there is a 67% chance it will mature as a top quartile.
But how reliable is historical performance? The issue is especially significant where Asian PE assets and managers are concerned. Asia’s PE industry is too young to have established a dependable track record but, simultaneously, allocations to the region are increasing. Deals by the top 10 PE managers worldwide by asset size went 5% to Asia in 2006-2007. In the first five months of 2011, Asia accounted for 23% of such deals, according to Preqin.
Yet, “the PE universe in Asia is relatively small, and the PE industry in the region is also relatively new so there aren’t many managers in Asia with a track record that justifies managing funds of large sizes. While we think it’s imperative to invest with top-quartile managers, we also have to ask whether their top quartile performance is repeatable. Our job is to determine whether a general partner can generate performance, even if market conditions in Asia aren’t quite as favourable as they have been in the past,” says Kahn.
However, INSEAD’s research shows that Asian PE performance is currently not highly correlated with listed equity market performance, unlike in developed Western markets. The study concludes that market performance only explains 15% of Asian PE’s performance. Michael Prahl, head of research at INSEAD’s Global Private Equity Initiative, estimates that 70% of reported exits in Asia outperform public markets, and 37% of reported exits outperformed listed equity markets by two or more times. Even so, he cautions that unsuccessful exits and write-offs are less likely to be reported, hence the data will be skewed. But generally, the data suggests that company-specific and investment-specific factors, including the skill of the PE manager, largely determine performance.
The conditions underlying PE performance differs in various Asian markets. Prahl notes that there is a marked difference between PE exits in India and China. In India, most PE assets exit via mergers and acquisitions while in China, the majority of exits are via initial public offerings. Hence, “in China, PE returns might be subject to boom and bust markets more than in India. The exit data also implies that risks can be higher in China because the PE investees tend to be smaller, younger companies controlled by an entrepreneur. In India, the investees tend to be more mature companies seeking growth or are established enough for trade buys or an international listing,” he says.
There are ways to manage the deal risks specific to Asia, Prahl suggests. General partners can ask for put options that allow an early exit under certain conditions such as falling short of key performance indicators or the failure to float after five years. “But there is counterparty risk at the point of enforcement,” he says.
Prahl also notices venture capital flavours in some Asian PE deal structures, especially where it involves younger companies. These include a mixture of debt and equity, or the issuance of various share classes. Some Asian managers also keep assets in the portfolio for two or three years after IPO, which can help to lower overall portfolio risk; there is liquidity and familiarity with the investee.
Overall, Asian PE performance is more volatile than assets in developed markets in the West. INSEAD’s study of returns, based on Cambridge Associates’ data on IRR after fees, expenses and carried interest, shows that the Asian Private Equity Index’s one-year return is 37%, five-year return is 12% and 10-year return is 7.3%. The Western European index, in US dollars, is comparatively smoother: one-year returns of 19%, five-year gains of 15.9% and 10-year performance of 16.9%. The US index’s one-year return is 13.8%, three-year is 9.7% and 10-year is 7.8%.