Waving or drowning?

Word that asset allocators at European insurance companies and pension funds are poised to increase funds dedicated to private equity is a welcome development. But then again, that really depends on the levels of inflows and over what period of time.

The problem with real money players is that they collectively control a vast wall of money, and tend to move herd-like into markets. The net result in something like buyouts can be a precipitous decline in returns as liquidity-induced competition drives purchase multiples through the roof.

Just look at what happened to hedge funds. When institutional cash started to move meaningfully into hedge funds and funds-of-funds two or three years back, returns started to slide because the highly contrived investment styles of hedge funds simply couldn’t be scaled up.

The best managers closed their funds to new money in order to maintain payouts, while returns at many of the rest became pedestrian against their own historical returns. As the volume of assets continues to increase exponentially, as disclosure rules tighten, and as regulatory oversight increases, the hedge fund industry risks becoming a commodity business with returns to match.

The buyout world operates under a similar dynamic as hedge funds. The difference between meeting hurdle internal rates of return and falling flat on your face in the kind of neutral market environment we’re in now – especially with rising acquisition multiples – can be pretty slight.

Think about the numbers involved. There’s something in the region of €7trn of insurance and pension fund money under management in Europe. A straw poll of top-line insurers and pension fund managers representing around 10% of this total revealed that allocations to private equity would increase to around 2.8%.

Scaled up to represent the entirety of funds under management suggests that €85bn in cash could be winding its way to venture capital and buyouts. The experience of the US, where institutional allocations are much higher, could be worth analysing here.

With public equity returns looking uninspiring, corporate capex spend unlikely to drive earnings aggressively, and the much-vaunted wave of corporate M&A still some way off, it’s no wonder fund managers are looking to alternatives.

In reality, we won’t get close to that kind of inflow in the medium term, but the real point here is that in the grand scheme of things, it will take no more than an imperceptible shift in institutional mindset to unleash a wave of money that could overwhelm a European private equity market that lacks the institutional infrastructure to deal with it.

As GPs prepare their assault on the market in the quest for new funds, the old adage: “be careful what you ask for”, may be worth remembering.

On another note, isn’t it wonderful how the whole notion of secondary buyouts has shifted? Not too long ago, secondaries were seen as the last resort of a desperate seller. They were something not to be mentioned in polite company. Just because they’ve become the only option in town for so many sellers, they’ve all of a sudden become “active portfolio management tools”. Funny that.