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Quest for alpha drives limited partners to focus on concentrated PE portfolios

A private equity survey of general partners and limited partners by bfinance, a financial services consulting firm, shows a fall in expected internal rate of returns of five to ten per cent over the coming years. 

Combined with expectations by over 81 per cent of limited partners of higher dispersion and significant increased volatility of private equity returns, 71 per cent of institutions surveyed plan to narrow existing general partner relationships and narrow the number of funds in their portfolios to avoid the expected compression of returns.

The survey shows that over 74 per cent of limited partners target net returns in IRR terms above 15 per cent from private equity investments, continuing to make private equity play a key role in institutional portfolios as a source of return enhancement and risk diversification.

Allocations to private equity are mostly stable, despite the vast majority expecting to see average returns in the industry fall.

Responses from limited partners and general partners indicate the reasons for expected compression of industry returns are three fold: significant capital over-hang (un-invested capital) pushing mangers to aggressively try to find opportunities at often higher prices, reduced and more selective access to leverage and a more challenging economic environment affecting companies’ growth. It is this backdrop which is also driving expectations of a wider dispersion of returns.

The survey also found that 71 per cent of limited partners continue to allocate to private equity as a way to obtain return enhancement in their portfolio. Seventy per cent expect private equity strategies (buyout, venture and special situations) to return in IRR terms above 15 per cent and 31 per cent of limited partners expect returns above 20 per cent.

Sixty six per cent of limited partners expect general industry returns in IRR terms to compress by five to ten per cent with general partners even more pessimistic; 73 per cent expect internal rate of return compression of five to ten per cent and 12 per cent expect a decline of over ten per cent.

Over half (54 per cent) of limited partners indicate that they do not expect to accept any return compression in their own portfolios and 46 per cent expect to accept five to ten per cent in IRR terms.

Seventy one per cent of limited partners expect to narrow the number of general partner relationships to reduce the dispersion and enhance private equity returns compared to the expected compressed average returns.

The majority (97 per cent) of general partners expect to maintain or increase assets under management between now and 2015. Despite 85 per cent of them forecasting general compression of returns above five per cent, 69 per cent expect not to be affected at all directly by the expected industry wide compression.

Private equity return expectations diverge between limited partners and general partners. Thirty one per cent of institutional investors expect private equity returns in IRR terms above 20 per cent over the life a typical buyout fund compared to 53 per cent per cent of general partners.

Olivier Cassin, managing director, head of research and development at bfinance, says: “Private equity will remain a key source of diversification for institutional investors but in an environment of falling expected average returns combined with a greater dispersion, careful general partner selection will become even more important. Our survey highlights a trend which we see amongst our clients: limited partners are moving away from passive allocation to private equity and increasingly are seeking help to identify managers that will generate consistent returns in the future based on sustainable competitive edges. Consequently, we are experiencing a stronger demand for specialist investment advice in this area as investors seek to maintain the quality of their exposure.”

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