The past 10 years has seen private equity undergo a rapid evolution to become a global and wide reaching industry. To get here, the industry has been through a number of cycles, from the early days when it was dominated by venture capital, to more recent times, when mega buyouts were making the headlines and occupying the larger part of the sector’s fundraising and investment volume. At the same time, we have witnessed the global expansion of private equity, from its origins in the US through to Europe and now into Asia and other parts of the world. This growth has been matched over the years by increasing investor appetite for the asset class – a trend which has begun to be challenged by the recent turbulence in the credit markets.
So what does the future hold for private equity and its investors? There is no doubt that private equity will continue to play a significant role in modern portfolio management, but it will also undergo fundamental changes which will continue to shape the industry.
Globalization and economic change
The globalization and efficiency increases in traditional business models that we see today will certainly continue as the world becomes more and more competitive. At the same time, the globalization of the private equity industry itself will also see it play an increasingly important role as a driver of economic change. Private equity allows companies to participate in the M&A market and to do so very quickly, either by making acquisitions or by divesting non-core business divisions. In this way, it is enabling the restructuring of entire industry sectors, thereby increasing the speed of consolidation waves and reinforcing international competition. This is particularly the case in Asia and is evidenced by the development of the private equity market in the region. The growth of its private equity market is here to stay and over the next ten years, Asia will become one of the most important regions for private equity. This in turn will influence the development of many industry sectors around the globe.
The influence of capital markets
The past few years have shown a significant inflow of capital into private equity, with institutional investors globally allocating increasing amounts to the asset class. From a long term perspective, this trend is likely to remain as investors continue to expect private equity to strongly outperform the public markets. However, the recent performance levels we have seen cannot be expected to continue indefinitely. This holds true particularly for the unprecedented returns generated by managers in the large buyout sector over the past four years. A correction will almost certainly occur alongside any correction in capital markets – whether on the debt or public equity side. The correction initiated by the crisis in the US sub-prime mortgage market during this summer will consequently also leave its mark on private equity, affecting different segments in different ways. For example, whereas large buyouts will be adversely affected, the ‘distressed’ segment may benefit from the opportunities presented by such a correction. Such stress events in the financial markets are always possible and will generally be followed by intermediate periods where difficult market conditions prevail. Overall, however, we would not expect this to dampen investor appetite for private equity over the medium to long term.
Cycles and selection
That said – investors in private equity do face a number of challenges. Firstly, from the moment money is allocated to private equity until it is actually invested in a company by a fund manager, several years can pass. This means that there is almost no way of being able to play cycles in the private equity industry. So the best strategy is to invest continuously in the market year after year, committing regular amounts of money, thereby mitigating the risk associated with cycles.
Furthermore, investors should diversify between the different segments of private equity. One segment might offer the best return opportunities at one moment, but a few years later may see performance suffer. Consequently, long term portfolio construction across all segments (i.e. venture capital, development capital, small/mid/large buyouts, and distressed situations) remains essential to successful private equity investing, as does geographical diversification.
The last point concerns the selection of private equity managers. Historical evidence and supporting data show that the out-performance that private equity achieves over public equity depends on the quality of fund managers. Only by investing with the very best private equity fund managers can produce superior returns, not only in good times, but most importantly during difficult market environments. As such, success in private equity requires not just a regular allocation to the asset class but, moreover, it is a question of securing access to the best managers. Investors need to remember that the role of private equity is to grow businesses and that only those managers who are able to add tangible value to their investee companies – to support their growth and achieve a worthwhile exit – will ultimately also benefit their investors.