While private equity funds remain flush with cash, a shortage of good investment opportunities and structural challenges are hampering the industry’s recovery, according to a study and survey conducted by SEI.
Updating two previous surveys from 2009 and 2011, SEI’s latest study, “Key Course Adjustments for Breaking Through: Five Ways Private Equity Managers Can Optimise Their Competitive Advantage,” identified some positive industry trends.
Allocations to private equity are on the upswing; 36 per cent of investors surveyed this year said they are increasing their allocations to the asset class, versus 26 per cent in the 2011 survey. Additionally, new sources of capital are surfacing, including institutional investors and sovereign wealth funds in emerging markets.
The survey also found that an increasingly active secondary market is helping managers to exit investments despite the slowing pace of initial public offerings (IPOs). Sixty-one per cent of respondents said they use the secondary market in some way, compared to only 30 per cent in 2009, and two-thirds said secondary buyouts will be “a key driver of deal flow” in 2013.
At the same time, the study depicts a Darwinian climate of intensifying competition in which many funds will struggle to survive even as new ones come forward.
“At present, the private equity industry is suffering from too much cash, too few quality opportunities, and continuing difficulties with exit strategies,” says Phil Masterson, senior vice president and managing director for SEI’s investment manager services division. “What institutional investors and managers describe to us is an industry struggling to regain its balance.”
Among the key challenges facing the industry, the report cites:
– A dearth of acquisition targets. Some 4,500 funds with an estimated total of USD1trn in uncommitted assets are chasing a limited supply of opportunities. In fact, those surveyed named “finding quality investment opportunities” as the industry’s greatest challenge, far outstripping concerns with new regulation or tax increases.
– A “mountain of dry powder.” The industry’s oversupply of assets is driving up valuations of potential acquisitions at a time when rising equity markets are having the same effect. More than six out of 10 survey respondents said the industry’s surplus of cash is resulting in more competitive bidding situations, and 45 percent said it is raising sellers’ price expectations. It is also making new fundraising more difficult, according to nearly half of the managers surveyed.
– Rising performance pressures. Investors and consultants are increasingly looking to private equity investments as a source of higher returns, over portfolio diversification. They also rank performance as the second most important factor in fund selection. But many funds are being hobbled by unprofitable investments and the stiff competition for acquisitions. The report finds having invested at the peak, or been unable to invest all of the capital raised, some firms will simply be unable to produce positive returns for their limited partners.
The report suggests five steps private equity fund managers can take to become more competitive:
– Use untapped sources of capital.
– Adopt more flexible fee structures.
– Capitalise on the secondary market for exits.
– Leverage technology and operational partnerships.
– Implement standardised filing processes.