Following another strong year of returns in 2016, one of the biggest challenges facing private equity limited partners this year will be distinguishing between managers that are genuine value creators versus market beneficiaries, according to Pavilion Alternatives Group, a consultancy.
“The challenges for 2017 are those relating to the sector’s ongoing success,” Pavilion’s president Donn Cox said in a statement. “Our biggest concern for the year ahead is the continued increase in valuations as capital has flowed into the private equity sector.”
Cox said that when the economy slows at some point, “it will be interesting to see if certain investments can meet their return expectations. We attempt to manage this by advising clients to invest steadily across vintage years to ensure balanced exposure over time.”
Pavilion has released its annual review, which identifies several issues that will test private markets this year. These include dynamic political environments and the complex task of selecting which general partners to back in what is likely to be a more challenging investment environment.
Following are seven key challenges facing private markets in 2017, according to Pavilion analysts:
1. Who Made the Difference?
The past few years have been good for private equity. Managers have had access to abundant low-cost debt, seen very high levels of deal flow and enjoyed the best exit years in the history of private equity markets leading to record levels of distributions, according to Pavilion. But that still leaves the reinvestment decision: How much of the attractive returns can be attributed to the market and how much to the manager?
Market timing is less of an issue than in some other asset classes because of the nature of the assets and the holding periods in private equity, according to managing director Willian Charlton. Still, private equity managers can benefit or suffer from market conditions, he says.
According to Pavilion, making the distinction between market beneficiaries versus value creators requires extensive experience in the various private equity markets as well as deep knowledge of the individual fund managers including their team dynamics, their strategy and their value creation capabilities.
“It is much more difficult for LPs to delineate clearly the market’s contribution to performance from that of the manager,” Charlton says. “This is especially important as it is unlikely that the current, beneficial conditions will last through the next full private equity fund lifecycle.”
2. Larger Fund Sizes: Pluses and Minuses
Private equity investors increasingly have to decide whether to continue to back a successful GP that is raising a larger fund than its previous fund. “Successful private equity managers often seek larger funds for a number of reasons,” says managing director Richard Pugmire. “On the investment side, larger funds provide more capital to invest and allow the firm to build resources. Growth also provides more management fees and more incentive compensation, which helps retain and attract talented investment professionals.
“There may also be the desire to expand the investment platform from one strategy to multiple strategies, which can build a stronger presence and brand name in the marketplace and provide ancillary benefits to the fund. A larger fund can attract more LPs and increase interest in investing across the platform.”
Investors often rely on larger fund sizes to gain access, but they also have concerns about how more capital can affect the firm and strategy, potentially diluting characteristics that made it successful in the past.
Pavilion’s recommendation: Assessing strategic consistency, investment process, investment size and post-investment execution should be part of any due diligence process in order to understand the merits and potential risks of larger fund size.
3. Brexit and Investing in the U.K.
What effect will Brexit have on the private equity market in the U.K.? Pavilion says that even if activity declines at times, it is unlikely that the U.K. will go from being the biggest player in European private equity to an also-ran.
Pavilion recommends that investors looking for exposure to European private equity continue to invest in the U.K.’s best GPs, and keep in mind that private equity as an asset class tends to outperform in periods of uncertainty as buying opportunities may emerge.
“The basis of a sound long-term PE program is to maintain a relatively even investment pace without trying to time the market,” says Rhonda Ryan, managing director and head of Europe, Middle East and Africa. “The U.K. PE market remains deep providing significant GP choice.”
Ryan notes that the best managers have proven ability to make money for their investors in all market conditions, and some will also have an angle or a way to make money through operational improvements that create value.
4. Asian Investment Conundrum
Large institutional investors, increasingly focused on reducing the number of fund manager relationships globally, make larger investments into the biggest pan-Asian funds and end up with concentrated exposure to this end of the market. But often niche strategies and smaller country-focused funds that provide exposure to the smaller end of the market are the vehicles that offer the potential for outsize returns.
To enhance their overall returns, Pavilion says, investors should consider the benefits of supplementing their core exposure to certain pan-Asian funds with a satellite portfolio of select country-specific ones. “This approach may also help investors improve diversification across markets and sectors, including both the larger and smaller end of the market,” says Peter Pfister, managing director and head of Asia/Pacific.
5. Trump Effect on U.S. Direct Lending
How will the new Trump administration affect direct lending activity in the U.S.? Far from negatively, according to Pavilion. Rather, the expected rise in GDP growth should benefit the mid-market segment in particular, which is expected to increase its demand for flexible lending solutions. Pavilion says private credit fund managers are better equipped to offer these solutions than traditional bank lenders.
On the regulatory front, it says, there is a limit to what Trump can do to change the status quo. “He could reform Dodd-Frank, but Basel III is an international regulatory framework,” says managing director Elvire Perrin.
“The U.S. could relax certain thresholds which were set higher than the minimum required, but the new administration is not going to take the risk to overhaul this regulatory framework dramatically given the general consensus that Basel III capital requirements have strengthened U.S. banks.”
Pavilion says that to maintain an attractive premium in this growing and competitive area, it is critical for investors to understand how private credit managers differ in their offerings.
6. Family Office Direct investments
Family offices are increasingly enthusiastic about direct investing as they seek to diversify their assets in order to prepare for family succession. This stems in part from their own entrepreneurial backgrounds, and many have direct investments comprising between 25% and 50% of their overall alternatives allocation, according to Pavilion.
Managing director Raelan Lambert says families consider it “critical to stick to what they know when pursuing direct deals, as this typically provides the best chance to create a new opportunity or advantage.” They view the investment office as a cost center rather than a wealth creator, he says.
Pavilion recommends that family offices get quality advice to avoid resourcing challenges as their direct investing exposure increases.
7. Allocations and the Pressure to Invest
According to Pavilion, the current up-market will present a major challenge to institutional private equity teams in 2017 as it leads to an increasing gap between target private equity allocation numbers and actual allocations.
There are two causes: Private equity valuation lags public market valuations, and the private market asset class self-liquidates (as companies are sold, cash is returned to investors and net asset value is reduced). This may result in pressure to deploy capital fast enough to match the trajectory of the public markets and private equity fund distributions. Current public market performance, along with increasing LP allocations to private equity, has made prudent investing that much more difficult.
“The most publicized issue from a private markets allocation perspective is what is called the ‘denominator effect,’ when total investment portfolio value (the denominator) declines in relation to the private markets allocation due to overall declines in the public markets,” says Brad Young, managing director and head of private market advisory.
“Many portfolios have seen their current private market allocations placed in an overallocated position on more than one occasion. These are often temporary situations, but nonetheless cause stress for investment staff and their boards.”
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