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.