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Private equity investors worry about GP strategy drift, says Coller survey

Three-quarters of institutional investors in private equity are worried that private equity fund managers will stray into strategies or regions where they lack expertise, according to Coll

Three-quarters of institutional investors in private equity are worried that private equity fund managers will stray into strategies or regions where they lack expertise, according to Coller Capital’s latest Global Private Equity Barometer survey. North American limited partners see the danger as particularly acute, with 84 per cent of them perceiving GP ‘strategy drift’ as a risk to their returns.

Investors are aware that their own growing appetite for the asset class is partly to blame. Well over a third of LPs (38 per cent) are planning to increase their allocations to private equity over the next year, with just 3 per cent planning a reduction. Strong returns also continue to attract new investors to the asset class, with four out of five existing investors expecting a significant influx of new LPs over the next three years.

Investors believe that growing institutional appetite for the asset class will increase the premium on LP talent, with 77 per cent of respondents expecting the market for LP skills to become significantly more competitive over the next three years. Half of the LPs surveyed expect institutions to increase their recruitment from private equity firms as the talent war intensifies.

The best opportunities in private equity in the coming year will be in small and medium-sized European buyouts, LPs say. The lower end of the buyout market is expected to be attractive everywhere – especially for small (less than USD200m) and mid-market (deals of USD200m-USD1bn) investments.

In today’s climate, investors see the most attractive opportunities for GP investment in sectors with long-term growth potential such as healthcare and technology, while sectors most at risk from economic downturn, like real estate and consumer industries, are considered less attractive.

The prospect of a prolonged downturn is also reflected in a stronger preference for distressed debt. More than a quarter (28 per cent) of Asian LPs and almost a fifth (18 per cent) of European LPs plan to begin investing in distressed debt for the first time over the next 12 months, reflecting high return expectations, with half of all respondents expecting returns exceeding 16 per cent from distressed debt over the next three to five years.

Plans to commit to this sub-asset class for the first time are less pronounced among North American investors, of whom a far higher proportion (65 per cent) are already invested in distressed debt.

Mezzanine is also expected to attract more first-time commitments in the coming year. The proportion of Asian LPs investing in mezzanine is expected to double over the next 12 months, from 17 to 34 per cent. More modest first-time investment in North America and Europe will take LPs’ exposure to mezzanine in these regions to 50 per cent and 63 per cent respectively. More than two-thirds of all respondents, 70 per cent, expect returns exceeding 11 per cent from mezzanine over the next three to five years.

Investors are active buyers as well as sellers in the secondaries market. Some 22 per cent of respondents have sold assets as secondaries, and 35 per cent have bought assets in this way (excluding funds of funds.)

Although LPs think liquidity will be an important reason for selling in the next couple of years, the desire of investors to focus on their best-performing GPs is expected to be a still more important driver of sales. LP usage of secondaries to re-balance their portfolios between types of private equity (for example, between venture and buyout) is also expected to be a significant driver.

Sovereign wealth funds are engaging with private equity at many levels, not only as investors in private equity funds, where their importance is still growing, but also as players directly in the market itself. LPs are divided about the threat wealth funds pose to GPs, with 58 per cent think they are already or are becoming significant competitors to buyout firms. However, 80 per cent of investors expect significantly more strategic partnerships between GPs and wealth funds in the next couple of years.

‘We are living in interesting times,’ says Coller Capital chief investment officer Jeremy Coller. ‘Institutional appetite for private equity is growing, at a time when the climate for GP investment has become trickier.

‘This combination is rightly sounding warning bells among investors. They know the dispersion of returns between more and less able GPs rises in tougher times, so worrying about GP strategy drift and focusing more resources on their strongest managers are very sensible responses to today’s climate.’

The Global Private Equity Barometer is a twice-yearly overview of the plans and opinions of institutional investors in private equity based in North America, Europe and the Asia-Pacific region. The latest survey reflects the views of more than 100 private equity investors from around the world.

Founded in 1990, Coller Capital is a leading investor in the private equity secondaries market, acquiring original investors’ stakes in venture capital, buyout and mezzanine funds or portfolios of companies from corporate owners or backers. The firm launched Europe’s first secondaries fund in 1994, and the first global secondaries fund four years later.

Coller International Partners V, which closed in April last year with commitments of USD4.8bn, is the largest secondaries fund in the world, investing up to USD1bn in individual transactions. The firm’s landmark transactions include the USD1bn purchase of NatWest’s private equity portfolio from the Royal Bank of Scotland, and the acquisition of a corporate venture portfolio of 27 technology companies from Lucent’s Bell Labs.

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