Private equity comes of age
Is private equity beginning to grow up and graduate from being a fringe asset class to being accepted as a fully fledged member of the investment community? The fact that it is now going through some performance problems is almost reassuring in itself.
There was, for some years, a concern from many that such outlandish statements were being made about its achieved performance and its performance prospects, that it could not possibly all be true. I am sure a number of funds stayed away from the asset class because they could not believe much of the hype. The asset class must be heading for a fall, the cynics argued, but instead the performance claims continued to be made. Eventually, cynics have to be right. But that does not prove that the asset class should be ignored. Not investing in private equity just because some funds are going to fail is about as convincing an argument as believing in the accuracy of a stopped clock just because it is right twice a day.
However, the advantage of a fall from grace is that it enables an industry to take stock and decide where it will go from here. It is probably still early days in a private equity reassessment but a quiet revolution has started. From the gathering together of investors in a ‘knitting circle’ in the UK (now apparently to be known as the Private Equity Investors Association) to the proposed restart of the European Venture Investors Circle, at last some of the major investors are realising they have some power. Other leading private equity players are becoming quite realistic about the sector’s prospects and trying to lead return expectations down.
Most players still expect a substantial outperformance of private equity against the quoted market say 500 basis points but maybe now we are talking about 10% performance against 5% for quoted equity of the next few years and most people concede, sometimes still only privately, that we should not be leading expectations towards annual returns of 20 to 25%.
So, what has started this rethink of attitudes? Firstly, we have seen significant falls in fund raising and investment activity in both the US and Europe in 2001. However, it must be borne in mind that the statistics only fell to 1999 levels which were themselves record highs at the time. As might be expected the US exhibited greater swings than Europe and, according to Frank Borges of leading US secondary market players Landmark, there is strong anecdotal evidence that the trend is continuing in 2002. He believes the current downturn is driven by poor performance, over-allocation especially by US institutions and, of course, fear!
Borges believes that this fall-out has re-emphasised the need for investors to seek diversification within PE portfolios, in particular between US and Europe, venture against later stage opportunities and most by a vintage year of investment.
It seems quite clear now that a number of funds raised in 2000 are going to fail and the venture managers that raised those funds may simply disappear. Just as, in the late 1980s, we need a good clear out right now and unfortunately in the process a number of investors are going to get hurt. But the ones that choose the best managers and diversified properly in the first place are still going to see excellent returns in the long term.
For the brave, this is probably a great time to invest. PE multiples are much lower than they have been for a long time and this is compounded by the fact that profits are cyclically low too. With corporate restructuring as well this means that very attractive purchase prices can be negotiated.
Most pension funds need to be convinced. The most difficult time to persuade a person to invest is usually at the very time the best opportunities exist. Private equity salesmen need to get out there and sell, but the way they sell needs to change. Peter Flynn of leading private equity fund managers Pantheon believes the private equity world needs to fundamentally rethink its attitude to its investors. It should stop referring to its investors as limited partners or simply LPs and start thinking of them as clients. I must admit, I think the term LP is pretty condescending as it tends to remind investors of their limited rights to information rather than their limited responsibilities as partners.
Flynn believes that private equity firms are going to have to become much more client focused in the future.
At the moment, the private equity market has only captured the hearts of the the visionaries of the pension fund movement. It has yet to achieve a breakthrough to capture assets from the majority. To do this it must change its attitude to meet the challenges. Flynn believes there is evidence of an appetite to change and meet the needs of institutional investors but it is time for the whole industry to grow up and become much more professional in its sales and marketing attitudes. Maybe in the 21st century this side of the business will become as professional as the generation of the returns were for many in the 1990s.