Guy Fraser-Sampson argues that despite the attractions of private equity as an asset class, many pension funds will be tempted by sub-optimal strategies

The growth of the global private equity industry has been spectacular over the last decade and a half. In 1993, the first vintage year for European buyout funds when just over $1.5bn (€973m) was raised, there were those who said the European buyout industry had grown too large to be able to invest limited partner (LP) capital efficiently and that it might be a good time to be reducing exposure to the space.

Hindsight is a wonderful thing. Had the hawks had their way they would have missed out on the next two years, which proved to be the best-ever vintage years when significantly more money was raised and upper quartile IRRs were 49% and 60% respectively, resulting in possible serious consequences for their overall returns. So what may seem obvious at the time is not always right.

However, the lesson may be even subtler: perhaps the hawks were right in principle, if not in degree. They may have correctly grasped that there is a finite amount of money that can be invested in any market in an efficient manner and that once that barrier is breached the investment is pushed into sub-optimal opportunities. It may be that they simply drew the line in the wrong place.

Given that estimates of the money raised by European buyout in 2006 range from $76bn to $120bn - a 50-fold increase in just over a decade on even the most conservative figures - this principle clearly needs to be studied again. And the current credit crunch lends the situation greater urgency and piquancy.

Nor is the situation confined to European venture. If we look at the industry as a whole over the same time period, $28bn was raised globally in 1993, rising to $464bn in 2006. And it is not difficult to see that a dramatic increase in the number of very large funds is driving this growth. In 1993 there were just two funds worldwide in excess of $1bn; in 2006 there were 98. Yet it is important to realise just how binary the market is becoming. Since the beginning of 2001, the number of all "mega-funds" - those that have raised at least $1bn - make up less than 6% of the number of funds but they have raised more than 70% of the total capital.

All of which raises a classic paradox for many pension fund investors. European pension plans have lagged badly behind their US counterparts in allocating to alternative asset classes. Even if one adds private equity and hedge funds together, they account for just 1% of UK pension plan assets. Indeed the present funding deficit crisis can be directly traced to this failure of asset allocation. Had UK pension plans enjoyed anything like a Yale model allocation profile they would avoided the huge over-exposure to quoted markets that laid them low in 2001.

And although there are many who are now seeking to put this right to at least some degree by making small allocations to areas such as private equity, there are many more who are not.

The problems this raises are those of capacity, access and diminishing returns. Some private equity firms, most notably the Golden Circle of top US venture capitalists, have stuck to their core investment model, which means in turn sticking to roughly the same fund size every time they raise money. Unsurprisingly, since it is to these partnerships that every pension fund in the world wishes to commit money, they became ‘invitation only' many years ago. As a result, and despite what many of the world's funds of funds may say to the contrary, it is now impossible to deploy any fresh capital here. And this problem has now spread to any private equity fund that may be in demand, regardless of where it is located, or in what type of assets it proposes to invest. In the last few years, for example, problems with access have become a regular feature of the leading players in both the European and US mid-market buyout space.

As far as returns are concerned, we must be careful not to draw too over-specific conclusions from industry data that, given the way in which private equity funds work and the nature of the data themselves, give at best an indicative view of actual performance and for the first several years no clear picture at all. Yet there is mounting evidence to suggest the validity of what seems in any event to be a common sense proposition. The more money people are seeking to deploy in any one market, the more likely it must be that the returns earned from that market will be driven steadily down. In other words, there may well be an inverse relationship between fund size and fund returns.

Private equity will continue to be an attractive asset class, but it is unlikely to be as dramatically attractive relative to other asset classes as it was during the 1990s. The gap will close, and in the case of the very large buyout sector it may close to quite a narrow premium over quoted equity returns. What is unclear is the extent to which many pension fund investors have actually grasped this probability. The suspicion must be that there are many who are still gazing fondly at the vintage year returns of a dozen years ago, and that it may be these false expectations that are driving steadily rising fundraising levels.

For those levels have been rising steadily, and there seems little reason to suppose that in the long term this trend will reverse. In the short term, of course, there may be those who have been made sufficiently uneasy by the current credit crunch to seek to reduce their exposure to the large buyout funds over the next year or so. This is illogical. Because of the way in which the investment and cashflow cycles work within a private equity fund, one would need to be able to predict a whole raft of financial indicators several years in advance to be able to market-time one's commitments. A private equity fund is like laying down vintage wine untested with the intention of enjoying it in future years. Some of the largest Dutch pension funds, traditionally some of the most sophisticated in Europe, have already said publicly that they will be maintaining their commitment pace.

So investors are now facing something of a Catch-22. Those who did not start investing in private equity when they should (the figures were offering clear evidence of consistent out-performance from about 1993) now need to get capital to work in a hurry; in many cases this need is prompted by pension plan funding deficits.

However, private equity is not an asset class in which money can be put to work quickly, at least not effectively. For one thing there is the question of diversification by vintage year. The last raft of investors to flout this basic principle came badly unstuck during the dot-com boom of 1999-2000, with many losing some, or even most, of their long-term capital - something that should be all but impossible in private equity. In my book ‘Multi-Asset Class Investment Strategy' I calculated the capital risk (ie the risk of having a negative return over time) of a private equity fund portfolio, based on vintage years 1984 to 2004, as between 0.2% and 3.4% depending on the assumptions used.

The key word here really is ‘effectively'. For example, traditionally one of the most obvious ways of putting money to work quickly has been to buy existing fund interests in the secondary market. However, with increasing amounts of money, both specialist fund capital and LP capital, looking to access this space it has become a seller's market with a surplus to book value, rather than the traditional discount, becoming a frequent demand. It seems logical to assume that the specialist secondary funds will be able to continue to cherry pick the best deals, so it is unlikely that in practice this route represents a viable alternative for the lone LP.

The overriding problems for investors in the future will be those of capacity and access. This raises the question: where should LPs deploy their capital? Fortunately, most LPs seem content to commit money to second and third quartile US venture groups even though their returns have historically been lower than other sectors; if logic ever becomes the norm in investor behaviour then the problem will grow very much worse.

Intelligent LPs will look to areas where the bulk of their competitors are not investing. Obvious examples could be European venture, tiger economies such as Brazil, and newly emerging opportunities in south east Asia as countries like Taiwan and Indonesia reform their legal systems to facilitate private equity activity. In reality, this will not happen; the bulk of investors will not step outside their US venture/mega-buyout blinkered mindset.

Guy Fraser-Sampson is the author of ‘Private Equity as an Asset Class'