Where investors look for returns
Private equity continues to surge in popularity and has once again been propelled to the forefront of investor, media, political and public consciousness. But now the focus is on the mega leveraged buyouts that are sweeping across the US and Europe.
At the very top end, fund sizes have grown significantly and this in combination with abundant debt availability and the willingness of the largest firms to partner together to do deals means few companies are now beyond the purchasing power of the buyout firms. With buyouts now approaching a quarter of global M&A activity, private equity has hit the mainstream.
However, the media focus on the mega buyout arena risks under-representing the increasing diversity and complexity of the various strategies that exist within the broad umbrella of the private equity funding model and that have now become mature sub-sectors in their own right.
As more capital floods into the asset class and more managers compete for funding, many long-term investors are becoming increasingly sophisticated in their approach to managing their private equity allocations. Differentiation of strategy, diversification within private equity and the search for performance alpha are key considerations. More and more investors are finding that they can no longer select funds on a purely opportunistic basis but need to spend more of their time narrowing an increasingly busy and competitive field by making critical allocation decisions about where to cast their net.
According to Private Equity Intelligence, 684 funds closed in 2006 and a staggering 899 funds are in the market. In 2006, 22 buyout funds of over $2bn (€1.5bn) raised about 60% of the buyout total and about a third of total private equity. This represents a huge concentration of capital, but it is not overwhelming - two-thirds of commitments did not go into large buyout funds.
Investor allocations are now more complex than the simple buyout/venture split of the past. In the US, real estate funds have had a separate allocation in their own right for some time - justified by real estate's 16% share of the market - and are slowly taking hold in Europe, where real estate has historically been a direct activity for most institutions. Similarly, distressed debt, infrastructure, natural resources, mezzanine, secondaries and special situations are increasingly moving from ad-hoc exposures to targeted sub-allocations within the private equity portfolios of many institutions.
The areas that have experienced the most explosive growth in popularity over the past two years have been buyouts, real-estate, infrastructure and natural resources. However, despite much discussion about investment in distressed debt and turnaround funds acting as a hedge against a long anticipated buyout market ‘bust', growth in these fund types has been more modest.
Geographically, the US dominates, although at around 61% of the market it is less dominant than it once was. Europe represented just over a quarter of capital raised in 2006. Asia and rest of world-focused funds accounted for 11% of the total, excluding significant Asian allocations from some US and European domiciled funds.
However, more popular does not necessarily equate to better performance. In reviewing where the best performance has come from within private equity, the historic performance data for the entire Thomson Financial database (which contains over 2,700 European and US private equity funds) has been analysed to show which subsets of private equity have tended to underperform or outperform the pack.
This analysis has determined whether each fund fell above or below the median for the vintage year in which it was raised. Various sub-groups were then examined to see if funds within them showed a higher or lower incidence of outperformance than the universe as a whole. The large majority of permutations resulted in around 50% outperformance, which is to be expected, and small variations, at around 50%, were not viewed as demonstrating a statistically significant difference from the universe at large. However, a few sub-groups did demonstrate significant differences in performance - less than 40% or more than 60% of funds above the median.
This dataset cannot serve as a powerful predictive tool on future returns. However, it gives a fascinating retrospective insight into patterns of historic risk and return against which past allocation decisions can be judged.
This analysis conforms very closely to current investor preferences: large buyout funds and European mid-market buyout funds are attracting significant capital and European venture and southern European funds are still perceived as out of favour.
It does throw up a couple of interesting correlations, however. Seed and early stage venture is a serial underperformer. Mezzanine funds tend to outperform but in many cases have lower risk characteristics, and the very smallest micro-cap buyout funds are also more likely to outperform. Within the umbrella of buyouts, Europe is more likely to outperform than the US.
Then there is the factor of fund size. The majority of outperforming categories involve larger than average funds or LBO funds, which tend themselves to be larger than average. For example, 23 out of the 26 European independent buyout funds of over $1bn in size in the dataset outperformed the median return and this is startlingly significant out-performance.
The skill with which investors have navigated the market in the past has been analysed by comparing the pooled returns with the quartile performance of all the funds in the Thomson dataset. The pooled returns reflect the weight of capital actually invested in the underlying funds, unlike the quartile returns, which do not. If the pooled return is higher than the median or even the top quartile then this is evidence that a disproportionate amount of capital is going into better performing funds.
In comparing the pooled return with the median and top quartile returns for various categories of private equity - PE, buyout and venture for both the US and Europe - it is clear that the pooled return outperforms the median by a substantial margin and in three cases - all European private equity, European venture and US venture - it outperforms the top quartile too. This demonstrates that investors are investing more capital into better performing funds.
Of course, large funds do not necessarily perform better because of their size, despite a number of arguments that are put forward by their managers for why a strategy based on large buyouts can generate superior risk adjusted returns. However, they are likely to have become large because they were viewed as being better and so likely to attract more demand from investors and many of them deal with this demand by increasing the size of their funds.
If funds became big because investors looked favourably on them after diligently analysing their underlying qualities then that creates a sustainable link between quality and size. However, the more investors use the circular logic of taking size as a proxy for quality, the weaker that link will become. There is increasing evidence for this phenomenon and certain investors are starting to re-evaluate the underling quality of the biggest funds - ironically due to potential strategic drift caused by the escalating fund sizes.
Laurence Zage is a managing director of Monument Group in London