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Lower private equity returns structural, say European LPs

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Over 75% of European limited partners (LPs) believe lower private equity returns since the financial crisis are structural and not cyclical, according to Coller Capital’s latest Global Private Equity Barometer

The six-monthly survey also suggests investors are taking advantage of what they consider to be “frothy” credit markets. It reveals a growing interest in and capacity for direct investment and co-investment, and indicates that some pension funds have completed the process of building necessary in-house private equity teams to implement these strategies.

While 73% of the full sample of respondents put lower returns down to structural problems, that figure rises to 78% among European LPs.

“The world has changed since the crash, with more onerous and costly regulation, lower risk appetite among investors, and rock-bottom interest rates,” said Stephen Ziff, a partner at Coller Capital. “The acceleration that LPs expect in cash calls and distributions are signs of a cyclical pick-up, but they don’t remove these structural factors.”

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While problems in private equity are acknowledged, it seems LPs still regard the asset class as compelling. The median respondent still expects a 5% risk premium for private equity relative to public equity, which Ziff described as “consistent” with what has been realised historically.

Nearly half of respondents think that increased economic volatility has made private equity more attractive, versus just 12% who think it has become less attractive, and there is a similar split between those who plan to increase their allocation and those who plan to reduce it. By contrast, more investors plan to reduce than increase their hedge fund allocations

LPs also seem to feel they are benefitting sustainably from the level of payment- in-kind (PIK) debt issuance that is being facilitated by ‘frothy’ credit markets. Almost three-quarters of respondents think that this signals “over-exuberance” on the part of credit investors, but two-thirds feel that one of the key ways in which borrowed money is being used at the moment – dividend re-caps – is at a level appropriate for the current point in the private equity cycle.

“LPs recognise that GPs [general partners] are able to access the debt markets with interest rates at fairly low levels,” said Ziff. “They like PIK debt because it’s not a drain on cash at this point in time, but the risks are there  – clearly one needs to re-pay. On dividend re-caps, LPs are seeing it as a source of distributions, and that’s reflecting findings elsewhere in the survey that respondents are expecting distributions to accelerate.”

The survey reveals that more than half of LPs have co-invested with GPs in the last two years, and that only one-in-ten had not been offered any co-investment opportunities over this period. The median LP currently invests 10% of its total commitments directly (on a standalone basis or via co-investment), and two-thirds of North American LPs and half of European LPs say they would like to be offered more co-investments.

“Co-investment is now a growing part of an LP’s armoury,” said Ziff. “Many LPs ask for co-investment opportunities, but they have to have the ability to evaluate co-investments when they are offered – and what these results show is that half LPs do have that capability.”

Part of that capability involves maintaining specialist in-house private equity teams to assess the deals. While a greater proportion of sovereign wealth funds, insurance companies and asset managers signal their intention to grow their teams over the next 12-18 months relative to the summer 2011 survey, fewer public pension funds plan to do so, and no corporate pension funds indicate that they plan to grow their teams in the new survey – down from almost 15% in 2011.

“If they plan to increase their private equity allocation or do more direct investing and co-investing, they need to build their teams to do that,” Ziff said. “If they don’t intend to do either of those things then there is less need to build a team. [These results] suggest that pension plans have done the majority of their team building. Some of the larger Canadian pension funds with very significant private equity programmes, for example, have increased their teams quite dramatically over recent years.”

The winter 2013-4 survey is based on a survey of 113 LPs undertaken for Coller Capital in September and October 2013. Some 41% of respondents are based in Europe, 24% of the global sample are pension funds and 17% are insurance companies.

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