GLOBAL – Private equity investors should prepare for possible lower returns due to a lack of top-tier private equity fund managers and increasing institutional inflows, says Mercer Investment Consulting.

According to a report released this week, the recent strong performance by private equity has encouraged institutional investors to commit new money to alternative investments.

“As a result of increased demand for private equity and a lack of quality investment managers in the market, slots in top funds were hard to come by,” said Chicago-based Mercer IC senior consultant and private equity specialist Caroline Aboutar.

While there was a “high probability” of generating good returns with quality managers, the investment consultancy urged private equity investors to properly evaluate managers’ track records and ensure due diligence standards were adequately met.

If not, investors could “regret” it in the future.

According to Aboutar, there has been a power shift, and fewer limited partners, the investors, were getting “investor-friendly” terms.

“By contrast, there are more examples of general partners fund_managers compressing fundraising schedules and insisting on solid commitments before limited partners complete formal due diligence.”

Aboutar warned of another - but less severe - private equity bubble in the future.

“Consequently, the effort to rapidly deploy as much capital as possible, coupled with pressure on deal valuations, may decrease return prospects,” she said.

According to Mercer IC London-based senior consultant Sanjay Mistry, European private equity managers face similar issues. Managers have attracted significant capital as many limited partner allocations are now equally split between the US and European buyout markets, he said.

“Manager selection is key," he told IPE.

"With the wide spread in performance between successful and average private equity managers the key issue for investors is ensuring that their private equity manager is able to deliver results in line with the investor's expectations,” said Mistry.

He explained that low private equity returns could be caused by increasing competition between private equity managers, a decline in public equity markets and the inability of private equity managers to leverage an investment.

"The first step for pension funds should be to fully understand the nature of the asset class and the implication of making an allocation,” said Mistry.

“This will provide them with a firm basis on which to set their investment parameters before making any commitments. If appropriate they should also seek professional advice."

He added that several new European markets – France, Germany, Italy and Spain - are “slowly” opening up to private equity investors, while the UK and Scandinavian markets are already “comfortable” in the area of private equity.