Though benchmark returns may be slowing after two years of record returns, limited partners still favour the asset class over public markets…
While nearly 50% of firms surveyed in the latest Private Equity Wire survey believe that returns in PE will decrease, LPs haven’t been put off the asset class and still believe that private equity will deliver good returns.
“I think that this is just a burgeoning asset class that will continue to grow. When you’re invested in your [fund] vehicle, you’re probably not sweating quarterly marks as much but if you’ve got more of a liquid portfolio, which may be far more driven by public markets, then you’re concerned,” says Simon Finn at Intriva Capital.
According to MidOcean managing director, Daniel Penn, LPs generally expect returns to be moderate in 2022 versus 2021 but are bullish on the private equity asset class long-term.
Investment manager Neuberger Berman believes institutional investors overwhelmingly want to maintain or increase their exposure to private markets. However, investors are being impacted by slower exits and rapid declines in public markets, which can cause big shifts in their asset allocation mix. Investors aren’t lacking conviction in private markets but may be lacking capacity.
UK pension pool, Border to Coast, remains confident in its PE exposures and expects to continue deploying in the asset class.
“We continue to believe high quality private equity managers have levers they can pull up from an operational improvement perspective to continue to drive value. We remain confident in the long-term outlook,” says portfolio manager, Christian Dobson.
Sophisticated enough
While some fund returns may have dropped, LPs continue to see the value of a long-term approach to private equity investing.
“I suspect that private equity returns won’t be as strong over the next few years, particularly compared to performance last year. Last year, 2021, was a banner year for most firms, particularly from an exit perspective, so it would be hard for returns to continue at that level. But we do still expect private equity returns to be favourable versus public market equivalents, mostly driven by the illiquidity premium,” Dobson says.
The majority of LPs are sophisticated enough to look through economic cycles but investment consultants have been educating their clients to view the asset class as part of a long-term approach, especially after the panic engendered by the last financial crisis in 2008.
According to such consultants, seasoned investors won’t be panicking about a potential slow-down, but more recent entrants to the asset class may worry.
Some LPs are becoming increasingly concerned about the denominator effect after two strong years of allocations and returns which will leave certain LPs overweight in private equity until public markets recover.
“LPs typically have a range of allocation per asset class. Due to the denominator effect, they’re not so keen on PE now, even if on paper, it performs better than other assets. They tend to reduce when things go well, and vice versa,” says one GP.
Some of the more astute LPs also recognise that recession year fund vintages – if 2022 or 2023 prove to be recessionary – have historically offered outsized returns.
“I believe most investors have understood by now that vintage diversification is really important,” says Nils Rode at Schroders Capital. “You see in our analysis that recession years tend to be very good vintages. Most investors know that. The question is, can they convince everybody around them? And might they run into some hard limits and a denominator effect that makes it more difficult for them to continue. Performance is not the main concern from investors from what I observe currently, it’s more about the denominator effect.”
Secondary solution
One solution to the denominator could involve selling assets or fund stakes on the secondary market.
“LPs have gotten much better at using the secondary sale as a portfolio management tool. That’s one reason why the secondary market has grown so much,” says Brad Young, global CIO, private markets, Mercer.
It’s clear that LPs are being more careful and retaining an element of caution as we enter Q3 and Q4.
“I think the uncertainty of how valuations are going to shake out on the private side has led a lot of LPs to slow down and reassess where they want to be. Many of them have gone heavily into technology private equity investing; they want to reallocate that to some other parts of private equity,” says a partner at a large US-based private equity fund.
“We’ve seen a number of LPs hit the pause button in terms of additional allocations. They want to see how things will play out throughout the remainder of the year,” adds a partner at a mid-market private equity fund.
Manager selection will also prove key in the upcoming months, with LPs looking to reallocate to the best GPs they have relationships with.
“One of the biggest challenges LPs are going to go through is how to choose the best managers. There are a lot of good managers who performed well and they will probably run into some challenges since they’re not going to make the roster with every LP,” notes Young.
“When it comes to manager selection, it’s important to set the bar high – we know that there are managers that can find the best businesses regardless of the market cycle,” observes Joshua Beers, principal, head of private equity investments at NEPC.
“There will be parts of this market that will suffer, resulting in poor returns. We’ve lived through these market cycles before, and we understand the importance of backing the very best, those with experience and resilience, as those managers are often the ones that produce stronger risk-adjusted returns,” he says.
Commitment issues
LPs are also seeking more commitment and stability from their GPs so they can plan ahead and make more informed decisions with their allocations.
“A more recent trend I’ve seen is investors asking fund managers who are currently fundraising what their plans are for future fundraising for the next one to three years. Some fund managers have found it helpful to give their investors a sense of their investment plans and pace and when they should expect to see them back in the market again. That’s been helpful, both for investors who are trying to manage allocations of capital during this flurry of fundraising, and also helpful from the fund manager’s perspective and getting investors to focus on the current fundraising they’re doing,” notes Kerry Shriver, partner at law firm Proskauer.
The latest Coller Capital Global Private Equity Barometer reported that private equity portfolios outperformed public equity portfolios since the financial crisis according to limited partners. The majority, 70%, of LPs stated as such, confirming that PE will continue to be a sought-after asset class for among them.
The strategies expected to perform particularly well in the coming months include distressed strategies, credit and infrastructure.
“In a more volatile and challenging market, we look to special situation strategies, such as distressed for control and operational turnaround focused strategies – they should have opportunities to do well,” notes Dobson.
The Private Equity Wire survey supports this, with over 20% of respondents stating that they expect to see strong returns from special and turnaround strategies. Other strategies which are proving favourable include growth equity (23.1%) and buy-out strategies (30.8%).
“I see an interesting opportunity in private credit as banks have retrenched. Private credit strategies are typically linked to the base rates. As they have a margin on a base rate, their total rate of return increases as rates are ticking up,” observes Joana Rocha Scaff, head of Europe private equity at Neuberger Berman.
“Infrastructure is also quite interesting because generally you’re investing in essential, long-duration assets. They often have barriers to entry which make their cash flow relatively predictable and stable, and generally also have an element of inflation protection, which is quite important in this environment,” she adds. 
