When the coronavirus crisis was ripping through the public markets near the end of the first quarter of 2020, private equity investors were bracing for the worst.
But when the quick rebound of public equities led to an almost-as-quick rebound on the private side, limited partners’ attention went back to some of the same structural concerns with the market they have had for years, a new survey from Probitas Partners has found.
Managing director Kelly DePonte told Buyouts he expected that the pandemic would be a larger concern going into the survey, which had 70 institutional investors as respondents.
“The answer we got in mid-November or early November was definitely different than the answer we would have gotten in April,” he told Buyouts. “It sort of allowed these structural issues that people have a lot of long-term fears about to come to the fore.”
One of the key concerns over the last several years for LPs is over-saturation in the private equity market. According to the study, 55 percent of respondents said there was “too much money pursuing too few attractive opportunities across all areas of private equity” as one of their four greatest fears regarding the private equity market. That is about the same as last year, when 54 percent placed that among their greatest concerns.
Investors prefer the mid-market because it is less efficient, with more and smaller deals happening than the upper market, where companies usually go into an auction run by a major investment bank.
But even so, 45 percent of respondents chose expensive mid-market purchase price multiples as a major fear. That is slightly less than last year, when 48 percent chose it, but still one of the top five concerns cited by LPs.
DePonte said this “dichotomy” of investors simultaneously preferring the mid-market but also feeling deal multiples there are too high is nothing new over the last few years.
“You’re really getting cognitive dissonance,” he said. “When that goes on year after year after year, it sort of catches your eye.”
When it comes to the larger end of the market, investors have a couple of major concerns. More LPs are side-eyeing larger private equity firms diversifying themselves into generalized asset managers, concerned they may be moving away from their strengths. Last year, 20 percent of respondents chose this as one of their greatest fears. This year, 33 percent did. Notably, 78 percent of public pensions mentioned this as one of their top concerns.
Investors are also concerned about fee levels on larger funds destroying alignment between fund managers and investors. This concern did not crack the top five last year, but this year 28 percent of respondents chose it.
DePonte said that as funds get into the multi-billion dollar range, the management fees become profits for the managers.
“The management fees 25 years ago were really meant to cover your costs as you deployed the capital and your real profits came from carried interest,” he said. “A lot of people are afraid that is not the way the market is being run now.”
DePonte said these fears stem from the 2008 financial crisis, which saw a much more prolonged return to the multiple of return LPs were expecting from funds they committed to in the run-up to the crisis. But, at the same time, GPs were still collecting fees as long as they did not write off an investment – meaning LPs felt those GPs were “protected” while they were not, which LPs felt did not reflect a proper alignment of interests.
“I think there’s a feeling that as a fund gets to be tremendously large, the management fees should probably go down even further than they are now,” DePonte said.
Action Item: read the Probitas Partners survey here.