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PE to win bigger share of investment portfolios

On balance, investors (LPs) expect private equity to win a greater share of balanced investment portfolios over the next 3-5 years (with 42% of LPs expecting an increase and 19% expecting a decrease), according to Coller Capital’s latest Global Private Equity Barometer.

But investors believe that LPs, GPs and governments must all change how they behave towards the industry.

Almost half of LPs think private equity is seen by those outside the industry as a ‘bad thing’ (most of the rest believing it is seen in a neutral light). Encouragingly, about two thirds of investors think the industry’s reputation is worse than it deserves. They themselves accept some blame for this: two thirds of LPs think investors (through bodies like ILPA) should be doing more to defend the industry.

Neither do investors think that all changes sponsored by Limited Partners are good for the industry – about half of private equity investors believe the growing number of LP special accounts (large fund commitments that guarantee special terms for individual LPs) are a generally negative development. Special accounts are seen as creating the potential for conflicts of interest between a fund’s Limited Partners.

For their part, GPs must continue to improve in terms of transparency and risk management, LPs say. About 60% of LPs believe that further improvements are needed across the industry (though only about 10% of investors think that most GPs are deficient in this area). These concerns are reflected in LPs’ views of the biggest risks facing the industry: while LPs see regulatory change and the macroeconomic environment as posing the greatest risks to private equity, GPs failing to learn from past mistakes or succumbing to strategy drift are also seen as major risks.

Commenting on the Barometer’s findings, Jeremy Coller, CIO of Coller Capital, says: “The early history of private equity was driven very much by GPs, but it’s clear that the challenges the industry faces today are as much issues for LPs as GPs. The risks to private equity’s reputation … the rapid growth in special accounts … the regulatory and tax environments for European venture … these are all issues where LPs have a uniquely influential or decisive voice. If private equity is to deliver its full potential for society – in terms of prosperity, jobs and competitiveness – investors will have to make their voices heard.”

All European governments say they want a strong domestic venture capital industry to support the growth of small businesses. However, three quarters of LPs believe the European venture capital industry will not reverse its decline without significant government support through an improved regulatory and tax environment. (The Barometer shows that the typical – ie, median – investor in European venture funds has made an overall return of just 0-5% from European VC – and over a third of European venture’s LP backers have lost money overall.)

Conditions for European VC will remain challenging even with government support. While a majority (59%) of European LPs think more government support would make a crucial difference, only about a third of LPs from elsewhere in the world think European VC will revive even with more government help. However, many investors (71% of European LPs and 56% of Asia-Pacific LPs) think that corporate venturers could fill more of the early-stage funding gap (though North American investors are more sceptical).

The secondaries boom is expected to continue unabated. In the next 2-3 years, slightly more LPs plan to use the secondaries market – either as buyers or sellers of assets – than have used it in its entire history.

There is also a strong consensus about the likely returns from distressed debt funds. Three fifths of investors expect distressed debt to deliver annual net returns of 11-15% over the next 3-5 years, with almost all LPs (89%) expecting returns of 11%+ from distressed debt.

There has been a dramatic rise in direct investing into private companies by LPs in the last few years. In the Summer 2006 Barometer only about one third of fund investors also invested directly. This proportion has now grown to two thirds. The trend shows no sign of slowing – 42% of Limited Partners say they will increase their direct investing over the next three years.

Co-investing is similarly popular – with almost two thirds of LPs co-investing alongside GPs. In fact, about a third of LPs say that they actively seek out co-investment opportunities or give priority to GPs that offer them.

Unsurprisingly, investors see economic conditions diverging significantly in North America and Europe. They are almost unanimous in expecting economic recovery in North America in the next 12-18 months – however, only a quarter of LPs expect the same for Europe. Most LPs foresee stagnant or even deteriorating economic conditions in Europe.

To a certain extent, they expect private equity to buck this trend. LPs expect the exit environment for private equity to improve across the world, though they think this will be most marked in North America – 88% of LPs expect improving exit conditions in the North American market.

Interestingly, broad economic and market conditions have prompted European investors in particular to look favourably on private equity compared with other investment opportunities. While support for the asset class remains generally strong, with a balance of investors from all regions at least maintaining their target allocations, fully one third of European investors expect to increase their allocation to private equity over the next 12 months (compared with just 5% of European LPs looking to reduce it).

The exposure of the world’s investors to Asia-Pacific private equity will continue to grow rapidly over the next three years. 39% of European and North American LPs expect to have more than a tenth of their private equity commitments focused on the Asia-Pacific region within three years (compared with just 15% and 21% of investors in those two regions today).

In terms of individual countries within the region, Australia is easily the most attractive destination for buyout investments, while LPs think China, India and Indonesia are currently the hottest markets for venture capital/growth investments.
 

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