Private equity co-investment programmes will continue to grow in popularity but investors face significant downside risk if they are poorly executed, according to Altius Associates’ annual survey.
In Europe, the report – The Key Challenges facing the private equity sector in 2014 – cites one of the key challenges as how to maintain investment and pricing discipline whilst deploying a significant amount of dry powder.
Turning to Asia, Altius counters the prevailing perception that cash distributions are continuing to slow down with managers struggling to return capital and recommends investors continue to grow their programmes in a disciplined and highly selective way as conditions for investing seem generally better compared to anytime over the past few years.
In emerging markets, Altius highlights that while investors have been increasing their allocations over the last 10 years exits still lag far behind and this is reflected in a significantly lower DPI (Distributions to Paid-In) ratio than the US and Europe. Altius identifies a key reason for this is the focus on growth capital investments, which generally take longer to create value than buyouts. In order for LPs to generate more liquidity out of their emerging markets exposure, Altius suggests they complement their portfolio with other types of strategies including secondaries and distressed funds.
Altius urges caution – and a significant underweighting – for real assets in emerging markets and predicts that 2014 will see the bloom finally fall from the rose of renewable energy, a ‘crowd favourite’ among many investors.
While 2013 saw a slowdown in the secondary market, Altius predicts a more robust market in the coming year, driven by a recovery in primary fundraising, changing regulations and a substantial opportunity in fund restructurings and secondary direct transactions.
Altius highlights the growing challenge of providing advice in an environment where overall fees and costs are often considered more important than investment returns. The report explains how the increasing focus of governments, and therefore trustees, on cost savings is driving decision-making not only on the advisers to use, the funds to invest in but also the types of investment to make.
While co-investment is here to stay and some LPs have found it to be additive to their private equity portfolio performance, starting and executing a programme can present significant challenges, not least in terms of having the appropriate structure in place to be able to respond to a short term opportunity. Without making structural adaptations many LPs can face difficulties in evaluating an investment relative to their portfolio, performing due diligence, preparing a recommendation and gaining approval from their investment committee within a matter of weeks and sometimes less.
Dr William Charlton, head of Americas investment at Altius, says: “Even if structural issues are addressed, two of the more difficult challenges faced in co-investing are those of adverse selection and aligning incentives. Our research shows that missing out on just a few of the better deals can lower the expected returns on the entire co-investment portfolio to an unattractive level. If GPs are better at investing below their maximum investment sizes then they are above, adverse selection may occur without any intentional ‘cherry-picking’ behaviour.
“Even when an LP invests on the same terms and at the same time as the GP, there can be divergence of interests. The GP might value a near-term, but lower, exit over a longer-term and higher exit due to fund raising pressures or the desire to ‘finish off’ the fund. Alternatively a GP might have an incentive to hold the investment longer to maximise their carry while the LP might prefer an earlier exit that would generate a higher IRR.
“The challenge for LPs interested in co-investment is to think through the creation or evolution of their structures and incentives so that they capture the benefits of co-investments while mitigating as many of the risks as possible.”
Private equity investors have increased their allocation to emerging markets over the last ten years, looking to capture faster economic growth in selected emerging market countries such as Brazil, China, and India. As a consequence, there has been a strong correlation between the amount of capital raised and the economic growth rates in emerging markets. However, LPs have expressed a certain level of disappointment with their emerging market fund portfolios, particularly with regards to the pace of realisation.
The prevailing view may be that Asian private equity is becoming less attractive relative to the US market, and Europe to a certain degree but Altius has seen a select group of Asian private equity managers distribute more capital in 2013. It believes that current market conditions for investing seem generally better as at any time over the past few years. The resulting challenge for LPs investing in Asia is to remain focused on growing their Asian programs, while remaining highly selective, disciplined and long-term oriented.
Over the past 12 months international investor concerns regarding the stability of Europe and the Euro have abated in favour of greater enthusiasm. Somewhat surprisingly Altius has also recently seen increasing excitement about investing in Southern Europe and there are a number of groups raising new funds in 2014. GPs and LPs will do well to remember the lessons learned from the financial crisis and ensure that the current buoyancy doesn’t translate into over exuberance.
Altius believes that private real assets represent one of the most attractive investment opportunities today in terms of portfolio diversification and inflation protection, it believes that there are three big challenges facing real assets investors, each of which comes with a health warning. These are addressing the limited track record of most private infrastructure managers; resisting the lure of renewable energy as well as emerging and frontier markets.
