Investment in private equity by pension funds and other institutional investors has been growing strongly in the last three years. According to the
According to some reports, this growth trend is likely to continue. A report from
Among the reasons for Deutsche Bank’s bullishness is the fact that alternatives can help institutions better control their investments, with many alternative asset managers putting money to work in a more aggressive way than traditional money managers. Despite this, the report points out that recent record fund raising and the credit squeeze will probably mean lower future returns.
In another report in September
Citigroup found that investment process and risk management were the main drivers of selecting alternative asset managers and were more important than performance. Nearly 90% of pension managers said investment process was a very important factor, while 80% highlighted risk management. Less than half said absolute performance was very important.
Other findings were that pension fund managers believe the typical 2% and 20% fee structures in private equity and hedge funds were unsustainable, except if performance justified them. Also, allocations to funds-of-funds are expected to decline, with less than half the managers surveyed currently investing with funds-of-funds and most saying they expect to reduce this over the next three years.
According to Peter Laib, managing director of fund-of-funds
“We’ve been developing models that allow investors to compare public and private equity performance and understand correlations, as well as being able to eliminate peaks and troughs so that a clearer picture can emerge,” says Laib.
Even with the current credit squeeze and likelihood of lower returns, Laib says that private equity still represents a good investment for pension funds. Laib says: “Many investors who got into private equity a few years ago have made returns of 30% to 40% and those kind of returns are unsustainable, but if a pension fund can make 15% from a diversified investment programme that’s not bad.”
John Gripton, head of investment management Europe at private equity asset manager
John Greenwood, portfolio manager at the
He adds that the current period could, in fact, be a good time for those GPs still able to access debt as there are likely to be competitively priced assets to be bought. For those GPs who may be seeking to put in higher levels of equity into deals as a direct result of the current credit crunch, there could also be opportunities for funds like CalPERS to co-invest, says Greenwood.
Multiples matter
As for returns, Greenwood says that for CalPERS, while the IRR is important, it is the multiple that matters. Again, given the current environment, GPs may have to hold underlying investee companies longer than in the past to achieve a certain multiple. But he says the pension fund still expects net returns to mirror those of the past, above 20% from the best firms in the mega fund segment and higher returns, reflecting the higher risks and greater opportunity, in the mid-market and smaller market segment. “These are expected returns for the best performers, not across the board, so we are still confident of seeing very good returns being generated by the top GPs.” he says.
One of the crucial elements in asset allocation, believes Greenwood, is being with the right GPs and not excessively exposed to any one region, sector or vintage year and that comes from experience: “CalPERS has been investing in private equity since 1991 and so have had many years to gain knowledge and build relationships with the best funds.”
Contradicting the forecast that pension funds more generally are likely to reduce their investment in fund-of-funds, CalPERS has moved towards mandating asset managers to invest in particular stages or geographical areas. In September, the fund allocated €400m to Standard Life Investments to invest in small and mid-market funds in Europe.
“This approach saves us the time and energy of ploughing through all the memoranda from GPs that arrive on our desks, giving us time to focus on our core portfolio. In the case of Standard Life, it will give us a window on and access to top managers and co-investment opportunities in Europe,” says Greenwood.
While allocations by pension funds to private equity continue to be strong, says John Gripton, the percentage depends on the nature of the pension fund. New pension funds, such as the state-backed funds created in Ireland and France, may have a greater appetite for long-term investments like private equity than funds that are more mature and cash negative. Gripton says: “In the UK, a small number of funds have a 7% to 8% exposure, although 3% to 4% is more common, while in much of Continental Europe it tends to be lower and in the US significantly higher.”
According to Erwin Roex, a partner at secondaries investor
But, given the credit squeeze is primarily affecting the mega deals at the moment, it is possible that there could be some re-assessment of asset allocation between the different private equity stages if the mega deals market is affected in the longer term. “The mega deals that are worth more than €10bn represent perhaps 40% of the total market, even though there have only been about 10 of these deals recently and nine of them were in the US,” says Adveq’s Peter Laib. He adds the mid-market and smaller deals will be less affected by the credit squeeze and the distressed market is likely to benefit from the current market conditions.
Unlike some others, Laib does not see private equity as necessarily part of an alternative investment market. Some investors see private equity as a standalone asset class and others as a sub-sector of equity rather than as anything particularly alternative, he says. “It all depends on the investor how they view private equity as a an asset class.”
Nevertheless, private equity is still seen as part of a wider alternative investment sector by many investors. According to
Even if pension fund investment in private equity continues to grow, there are some concerns about fee levels, according to Citigroup. Capital Dynamic’s John Gripton says that fee structures have not changed for a long time. “In the late 80s and early 90s fees were over 2%.We’ve seen that reduce a little but the size of funds has increased dramatically and so in overall terms fees have increased significantly.” Whether there will be pressure on fees in the future will depend on individual GPs’ performance. “For the very good managers fee levels are not generally an issue among LPs because the managers have generated such high net returns,” says Peter Laib.
He says while returns still play an important role in explaining why pension funds choose one rather than another GP, investment process and risk management have assumed a higher profile in recent years. “Investors want to be confident there are clear policies and responsibilities, so that it is clear how and why investment decisions were made. Good governance, checks and balances and compliance issues are all important.”
Coller’s Erwin Roex argues that investment process and risk management are intricately linked to performance in any case. “The reason investors highlight investment process and risk management is that they are good indicators of returns because they show that the GP has a well thought-out strategy that is implemented rigorously.” But he adds that a track record of good returns is still crucial in attracting investors, perhaps more so in private equity than some other asset classes because the gap between the top performers and the rest is so wide in private equity.
John Greenwood of CalPERS agrees performance is important but says that you always have to probe the details of the track records: “Sometimes you’re presented with a strong track record but then find that its profile is skewed by only a small number of successful investments with the rest having performed poorly. It’s important to look at how the performance is made up.”
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