2005 will see significant capital raised in private equity with forecasts of some $230b to be raised globally and within this, Europe’s share is forecast to be $60b. The significant increase in Funds raised naturally leads investors to question whether this is a bubble with subsequent returns for private equity being adversely affected as happened with the bubble in US venture capital during the late 1990s. This article addresses the issue of whether there is too much money flowing into private equity and how investors can achieve strong returns from the asset class in the future.
The experience of venture capital in the late 1990s provides an excellent example of a high level of fund-raising that led to subsequent very negative investment returns. This was a classic bubble with too much money chasing too few opportunities and was the result of a classic rear-view-mirror investor mentality. It was a case of ‘irrational exuberance’, with investors chasing what had done well, rather than looking forward to the future return prospects.
In the case of European Private Equity, and buyouts in particular, we do not believe that the large increase in fund raising is a bubble. The trend of investors to increase their allocation to private equity is rational from a relative and absolute risk/return perspective.
Historically, private equity has exhibited superior risk and return characteristics relative to quoted equities. This can be attributed to the concentrated investment and ownership structure of private equity which provides much greater focus and the ability to implement change in the companies being managed. In contrast, typical quoted managers invest into multiple companies and therefore do not have the focus or the means to implement change. In addition, the incentive structures of private equity reward managers to extract long-term value from investments, therefore avoiding the short-term mentality of quoted markets.
However, while properly implemented private equity should continue to achieve strong returns relative to quoted over the medium-term, to achieve strong absolute returns requires careful attention to strategy – as we saw in the late 1990s private equity is not immune to market conditions.
Among other things (such as the economic environment), this requires identifying markets where the supply of opportunities is exceeded by the demand – for example, is there too much money being raised? Forecasting supply and demand requires forward looking investment judgement about the factors that influence these variables. On the demand side, it is important to note this extends beyond private equity funds raised and includes demand from corporate acquirers – currently private equity represents approximately 20% of M&A.
In Europe we believe that supply and demand for private equity remains broadly in balance and return prospects remain strong on an absolute as well as a relative basis. While demand and funds raised have and will increase, the European Private Equity market has not reached maturity and deal opportunities will continue to grow to meet increased supply.
The European market is at an attractive stage of development as economic underperformance has triggered a period of structural change. Structural change provides strong deal flow for managers and opportunities to add significant value to portfolio companies. We believe that in Europe there is clear evidence of bottom up reform as witnessed by the steady increase in buyout activity and accelerating returns to buyout managers. Restructuring is being supported by macro economic reform – most notably the creation of a single market, adoption of the single currency and gradual labour market reforms. The crucial point is that although the reform process is well underway, the process has further to run.
Of more concern is the US market which is significantly more mature - much of the low hanging fruit for private equity firms has already been captured. In addition, there remain concerns over the medium-term prospects for the US economy given the significant economic imbalances that exist.
Whilst the supply of opportunities in Europe remains strong, increased demand/competition will ultimately put some pressure on the aggregate investment returns of the market. This is particularly true in sectors of the market where there are relatively few inefficiencies for managers to exploit, such as mega buyouts. To be successful managers will need to adapt to this competition and identify new ways to generate strong returns whether through operational improvement, sector specialisation, financial structuring, superior strategic insight or improved deal sourcing. Whilst the majority of managers have or will be able to make this step it will not be the case universally. As a result returns between different managers will vary significantly and selecting top managers will become increasingly important.
Additionally, the increased specialisation and segregation of the market required to compete in Europe will also make the selection of manager strategies, such as target investment size, style, sectors and countries, more important. The increased complexity of the market can be seen by the significant increase in the number of private equity managers in the European market.
The increased number of managers and complexity of strategies make it more difficult for investors to isolate superior returns from private equity. To achieve consistently strong risk adjusted rewards in the future will require significant levels (quantity and quality) of investment resource to thoroughly research the larger opportunity set. While large pension funds and institutional investors were able to successfully select European managers, with limited internal resource, this is now increasingly difficult.
Another important issue for institutional investors, as a result of the increased demand for European Private Equity, is being able to access the top performing private equity managers. A number of private equity managers in Europe are likely to be able to raise funds without having to open them to new investors. In the more competitive environment it will be vital to access these top managers to achieve superior returns. Accordingly, it is important to develop and maintain strong relationships with the top private equity managers.
In summary, the increase in European private equity funds raised is rational, both in terms of future relative and absolute return prospects. However, the increased competition will make strategy and manager selection increasingly important to generate strong returns. We believe that this requires increased investment research and importantly quality forward looking investment professionals to assess the opportunities.