The news this week that such an influential and large institutional investor as Calpers is to increase its private equity investments by 40% is a great boost for private equity funds, especially for those on, or thinking about joining, the fundraising trail.
Not only should it help to stem the flow of investors contemplating turning their back on the industry (see Global Private Equity Barometer results below) but it also illustrates a growing maturity and understanding by large institutions as to how private equity works. Simply that slumping markets create acquisitions bargains. That private equity is of course like everything – cyclical.
Other positive and related news this week saw the publication of the December 31 2008 valuations for private equity funds by research outfit Prequin. Private equity has a long history of outperforming other asset classes and delivering superior returns to investors – but it had been largely expected that the December 31 valuations would see major write-downs that would wipe out much of this performance.
However, according to Prequin, the average private equity fund declined by 17% during 2008, a major decline by the industry’s previous stellar standards but not as bad as many had feared. Some 14% of funds were badly hit, with valuations down 40% or more, but 19% actually saw an increase in 2008, despite the global recession.
Buyout funds were harder hit, with average declines of 22%, but there were big differences across fund sizes. The smallest funds (US$500mn and below), which use relatively less leverage, escaped relatively unscathed, with valuations down only 8%; conversely, the biggest funds (US$7bn and above) were hit harder, with valuations down 35%.
Despite these few bright spots, LPs are still learning some difficult lessons, which is hardly surprising considering the unprecedented levels of fundraising that preceded the crash.
According to Coller Capital’s, Global Private Equity Barometer, Summer 2009, 20% of LPs plan a reduced allocation to private equity in the coming year while one in 10 private equity investors will default on fund commitments.
According to the Barometer, North American investors generally expect higher default rates from the global LP community than their counterparts in other regions. They foresee an average default rate of 13% compared with the 7%–8% expected by European and Asia-Pacific investors.
Mark Spinner, head of private equity at Eversheds, said: “In a similar way to direct private equity, where investors have used significant amounts of gearing when acquiring assets, many investors into the private equity sector LPs have also used gearing and future distributions to support the commitments made to a number of fundraisings, a strategy which now looks very perilous.
“Many limited partners, particularly those that are relatively new to the private equity asset class, would ideally like to reduce or withdraw their commitments to a number of funds and this is certain to lead to a number of defaults,” he said.
“Most limited partnership agreements contain various remedies, many of which are draconian, aimed at making sure limited partners do not default,” Spinner added. “In my view there will be more negotiated settlements, rather than litigation, as general partners and fund managers try to avoid wholesale defaults and collapsing of funds, preferring to allow those limited partners who want or need to reduce their commitments because they are over committed, to do so in a controlled way.
“The most likely situation is that those funds that are relatively modestly invested, with new or unproven teams or track records, are most at risk, with limited partners retaining the liquidity that they do have for the funds where it would be more painful economically to default and where the managers have serious track records of delivering sustainable value in the medium to long term,” he said