At the beginning of 2006, Ireland’s National Pension Reserve Fund announced that it was to increase investment in private equity to 8% by 2010, which will mean an allocation of about €2bn. Meanwhile, the French Pensions Reserve Fund has issued a tender for its first ever private equity programme, worth €1.5bn or 6% of its portfolio. These announcements came hot on the heels of the €11bn allocation to private equity by two Dutch public-sector pension funds, ABP and PGGM.
So, what is behind these decisions and how will these increased allocations be implemented in an already heated buyout market?
When it comes to state pension schemes, such as the Irish and French funds, the logic behind shifting more funds into alternative assets such as private equity, hedge funds and property is obvious. With ageing populations on the one hand and lower returns from traditional investments such as equity markets on the other, such funds are being squeezed from both directions.
Depending on the fund’s maturity, it is also true that the longer-term investment profile of pension funds fits well with private equity.
“You must bear in mind that most pension funds still have the vast majority of their money in more traditional assets, but we’ve still seen a significant shift to alternative assets in recent years and, if anything, that shift is not slowing but speeding up,” said Jeremy Coller, chief executive of secondaries specialist Coller Capital, which surveys institutional investment in private equity in its Global Private Equity Barometer.
According to the survey results for January, there is growing appetite for private equity from institutional investors, with more than 50% planning to increase their allocations to alternative assets.
While some in the industry fear that the increase in funds could simply increase competition for assets and thus push up prices even more, others believe the European private equity industry can absorb such increases in capital.
One of the reasons supporting the argument that this new investment can be absorbed is the fact that Europe is still way behind the US in terms of penetration. According to research firm Private Equity Intelligence, US pension funds are allocating around 4%–5% of their assets to private equity, compared with about 2% by European pension funds.
Lothian, a UK local authority pension fund, allocates 5% of its fund to private equity, but only has 2.5% invested or committed. Andrew Imrie, responsible for Lothian’s private equity investments, said Lothian has generally opted for fund-of-funds investments. This is because it can be difficult for a public sector pension fund, with relatively limited resources, to build relationships with top private equity funds directly.
He said that Lothian had not yet reached its allocations because ensuring that due diligence and legal documentation were in order had turned out to be a more complicated than expected. This was also partly due to a lack of internal resources at the local authority, he said.
Imrie added that some private equity funds were simplifying their legal documentation to attract public sector pension funds. However, the lack of transparency in hedge funds operating in the private equity sphere means that public sector pension funds would be unlikely to invest with these vehicles.
According to Bruno Raschle, founder and managing director at fund-of-funds Adveq, the increasing influx of pension fund money is good news for buyout funds.
“There are probably only about 600 companies worldwide that are not potential private equity targets, and that will continue to change as in the next 12 to 18 months I expect to see funds of €20bn to €25bn, partly as a result of growing pension fund investment,” Raschle said.
James Stewart, a partner at UK private equity firm ECI, welcomed the new pension fund money but cautioned that, in the case of state or public sector pension funds, it was crucial that strategy was not directed by political aims.
“The problem is that sometimes governments try to direct such investment to meet political aims, such as building up investment in early-stage domestic companies, but if you do that it creates an artificial market,” Stewart said. “Funds need to be given the freedom of choice to invest their funds with the manager they want, and overseas if they want.”
He questioned the effectiveness of initiatives such as the UK government’s Northern Way, in which regional agencies are ploughing money into encouraging early-stage business innovation in the North of England.
Adveq’s Raschle agrees that there is sometimes some tension when it comes to state pension plans.
“Governments have seen how investment from Californian pension plan CalPers helped support local economic development, so there is some political pressure to encourage state pension plans, but there is also a recognition that these pension funds have to get a good return and that they will need global strategies to achieve their aims,” Raschle said.
He added that the swelling coffers of buyout houses would be crucial in helping European industry restructure in the face of growing global competition. But, while increasing institutional funds might benefit the buyout houses, it is a different story for venture capital. Raschle argued that in the case of venture capital, it would dilute returns.
There is little likelihood that the €11bn recently allocated by Dutch pension funds ABP and PGGM will go in politically motivated programmes, however. PGGM represents state healthcare and social work employees and ABP civil servants. The two funds are the shareholders and main clients of private equity house Alpinvest Partners.
The €11bn allocation, one of the largest mandates ever granted in the international private equity markets, will cover the investment period 2006 to 2008 and will be used for direct investments through co-investments with other funds, primary and secondary fund investments, as well as mezzanine transactions.
Wim Borgdorff, managing partner of fund investments at Alpinvest, said the whole approach of pension funds to private markets such as private equity has changed dramatically in recent years.
Such investments used to be regarded as the “Wild West”, he said, because it was seen as hard to measure performance and manage risk.
“The paradigm shift occurred when it was realised that the public markets also carried risk and that the private market was not so exposed to market sentiment and was often a good fit with the long-term objectives of pension funds,” said Borgdorff. “Another key attraction, of course, was the strong returns from private markets.”
Borgdorff emphasised that the shift, while highly significant, should still be kept in perspective. PGGM has 7.5% allocated to private equity and ABP, which is a more mature pension fund, 4%. He said that the increased sums going into private equity could be absorbed and that returns would not necessarily suffer.
The market has consistently demonstrated a capacity to adapt to a changing environment and take on new opportunities over time, he argued.
“Private equity has provided average returns over the last 20 years of 15%–20% a year and our belief is that we haven’t seen the end of that,” said Borgdorff. “I don’t see an inevitable ceiling or plateau, especially when you consider that private equity as a proportion of M&A in Europe is still catching up with the US and in Asia is at very low levels.”
He added that firms were raising bigger funds and building their teams, in response to increasing investment flows from LPs, and that those firms continued to demonstrate success.
Of course, a key issue here is whether pension funds that are new to private equity, or indeed some of those that already have a track record, are able to get into the successful funds.
Stefan Hepp, founder of SCM Strategic Capital Management, a gatekeeper focusing on institutional investment, said that for those new to private equity it would be difficult to access the investments they want.
“There’s a general oversubscription in the market and so there are entry barriers to new investors,” he said, adding that to be successful investors really need to be invested with good teams.
Jeremy Coller of Coller Capital agreed, noting that it was very difficult to enter a mature market in which all the investors knew who the best GPs are. “There’s only a limited amount that can be invested with the best performers and so it’s hard to get in if you haven’t already got a relationship with them,” he said.
As an example, Coller pointed to US venture, which is offering very good returns but the size of the funds is so limited that many investors simply cannot access the market. “It’s now becoming increasingly competitive to get into European buyout funds,” he said.
According to Coller’s recent survey, more than two-thirds of LPs have not been able to obtain their planned allocations to North American venture funds in the past 12 months, while more than one in five LPs were unable to obtain allocations to their European buyout funds of choice.
Ronan Cunningham, head of private equity at the National Pension Reserve Fund (NPRF) in Ireland, acknowledged that getting into top funds could be challenging for a new entrant but the fact that the NPRF had individuals with wide experience of private equity and contacts among GPs was likely to help it develop relationships.
Cunningham said that the NPRF was seeking to differentiate itself in the way it developed relationships with GPs and that the fund’s €3bn private equity allocation and its long-term investment time horizon were positive factors that it could use.
“We’re one of the biggest Europe-based LPs and we’re not required to make any liquidity draw-downs until 2025, which is quite attractive to GPs,” said Cunningham.
NPRF investment will be in the US and Europe on a broadly equal basis. While the main investment focus will be in the buyout area, it is also planned to allocate funds to venture. So far, the fund has invested €180m in total, in buyout funds at CVC, Vestar and Clayton Dubilier & Rice.
While the NPRF appears already to have developed good relationships with some GPs, not every new entrant will be as successful. C said that LPs’ difficulty in getting into their desired funds was an important issue because in private equity it really did make a difference.
“In private equity, it’s more important to be in the top quartile than in some other investments,” he said. “In good times the medium-performing GPs may do well but in difficult times they won’t.”
Coller expects pension funds new to private equity to start off with funds-of-funds.
“Even if a pension fund is expert on equities and bonds, they won’t know much about individual private equity funds,” he said. “Also, pension funds often don’t have the in-house resources to build relationships with GPs by travelling round and visiting them.”
Alasdair Douglas, head of the investment funds group at law firm Travers Smith, agreed. “I think the increasing interest of pension funds in this area is good news for the gatekeepers, who put pension money into particular private equity funds,” he said.
But SCM’s Stefan Hepp said that patience would be essential for new entrants to the market or those who wished to increase their exposure significantly to private equity. Fundamentally, the influx of new money would be positive for private equity but the implementation would be complicated.
“I would advise patience and if a pension fund hasn’t invested much in private equity in the last few years and wants to catch up quickly, it should think twice,” Hepp said. “It is best to spend time building up relationships with GPs, perhaps using others to help you with this, before committing large sums.”
Hepp added that he expected more money going into private equity to result in more competition for assets, and thus higher prices. Newer entrants to private equity might be tempted to invest with whichever fund would allow them in, but that could end in tears if there was pressure to invest in low quality assets.
“What I would not advise is for people to try and get into new funds at almost any price – you need to be with a GP who will have the discipline to walk away from a deal if it isn’t right,” Hepp said Investing in funds-of-funds would not solve the problem, he argued, because ultimately the capital invested with funds-of-funds had to be deployed.
Peter Linthwaite, chief executive of the British Venture Capital Association (BVCA), opposed the argument that a big increase in investment funds risked resulting in poor-quality private equity transactions, but he called on new investors to take a long-term approach.
“We don’t want new investors coming into the market for a year or two, as happened in 1999–2000 when lots of new funds invested, only to withdraw soon afterwards,” Linthwaite said.
He argued that buyout firms would not be raising more than they felt they could effectively invest and so newer entrants would probably find it hard to access the top funds. But despite this, Linthwaite pointed out that it was a maturing market in which bigger deals were being done requiring higher levels of funding: “Large companies that would not have been on the radar of private equity in the past are now potential targets,” he said.
The failsafe in terms of the deployment of capital, argued Linthwaite, was the remuneration structure of buyout houses. The way private equity managers were incentivised meant that it was simply not in their interests to make investments they felt would not provide good returns.
“That means that if a firm feels an investment will not benefit the overall fund, it won’t invest – so if a firm raised £500m but later concluded it could only invest £300m effectively it would rather cancel the remainder than invest it in poor-quality deals,” he said.
There are other factors that suggest private equity investments could find it harder to replicate the stellar returns of recent years, notably the increasing level of debt in deals and the rising prices of assets. Linthwaite acknowledged these factors but explained them in terms of the relatively stable economic outlook and the low cost of capital.
Ronan Cunningham of the Ireland’s NPRF said: “There has always been too much capital chasing too few good-quality deals and yet returns in recent years have been more than sufficient. The question is whether that is sustainable and that’s something we spend a lot of time debating.”