Should schemes prepare for lower private equity returns?

Written By: Emma Powell LAPF Investments

Emma Powell explores the recent historical performance of investment in private equity, concluding that schemes may need to moderate their returns expectations going forward

Historically low interest rates and dwindling return expectations of traditional asset classes has caused a surge in investment in private equity. According to data from Preqin, at the close of last year, firms led by Blackstone and Carlyle had amassed $1.5 trillion in unspent capital to invest in private companies, the highest year-end level on record. That is despite buyout deals also hitting their highest level since 2007, reaching $478 billion in value.

For local government pension schemes the promise of long-dated returns that are uncorrelated to public equity markets has enticed them into increasing their allocation to private equity. The asset class made up just 1% of local authority schemes’ allocation in 2004 – according to research by Pensions and Research Investment Consultants (PIRC) – but had grown to 5% by last year and constituted half of their exposure to alternatives.

LGPS investors making a small allocation have traditionally gained exposure to private equity by investing in funds overseen by third party fund-of-fund managers, which have a pre-agreed date on which they will stop making new investments and subsequently be wound-up.

Those funds usually invest in new projects for six years and are wound up in 10, although there is a standard extension period of two years in most fund agreements. Capital is used by private equity firms to take controlling stakes in companies, with the aim of improving the company’s capital structure and efficiency to exit the investment, via IPO or a secondary sale.

Only larger schemes have typically made direct or co-investments alongside the private equity manager, which requires more due diligence and investment skill but brings the reward of lower third-party fees.

Yet the advent of investment pools has made accessing private equity easier for LGPS funds, with LGPS Central and Northern establishing internal teams to take more control of private equity investments. The former launched its own investment vehicle in January 2019, comprising a sleeve undertaking investments in primary funds and another in direct, private equity co-investments. Investors included Cheshire Pension Fund, Leicestershire Pension Fund and Nottinghamshire Pension Fund.

That followed the launch of a new private equity structure by Local Pensions Partnership in 2017, which combined the £1.8 billion of private equity assets of its two shareholder funds, the London Pensions Fund Authority and Lancashire County Pension Fund, under the management of subsidiary LPP Investments (LPPI).

Public authority schemes’ scale makes private equity more accessible, says Hymans Robertson head of LGPS investment, David Walker. “The LGPS can take a long-term investment horizon and therefore benefit from the illiquidity premium,” says Walker. However, schemes also need to ensure they “manage vintage year distribution” too, says Walker, which means steadily deploying capital year-on-year.

“Because they’re open over the long-term, they don’t need to worry [too much] about short-term volatility,” agrees Neil Sellstrom, client services manager at PIRC.

Taking a longer-term investment view also reduces the risk of those schemes being forced to sell investments on the secondary market. Due to the ‘J curve’ effect – where investments perform more poorly in the earlier years – that can result in investors receiving a lower return than they might have done by keeping their investment locked away for the full term.

For LGPS, private equity was the best performing asset class during the year to March 2019, returning 15%, according to PIRC’s survey of 64 of those schemes. That compared with an 8.6% return from global equities, but also that of other alternatives such as infrastructure and property, which returned 11.7% and 6.1%, respectively. But even over the past decade private equity returned 10.2% for LGPS, according to the research, outperforming all asset classes except global equities, which returned 12.9%.

Has the market peaked?
Yet not all types of private equity investment may deliver the level of diversification versus public markets that investors have come to expect.

“If you’re building a private equity portfolio that consists entirely of large cap companies then I think the correlation you will have with public markets will be reasonably high,” says Marc Boheim, managing director at GSAM Alternative Investments & Manager Selection Group.

Relative to a standard public market portfolio, an investor will enjoy greater diversification from investing in venture or growth equity, than investing in buyouts, he says. However, these strategies may also come with a higher loss ratio, Bonheim adds, and among a portfolio of 25 to 30 companies, you would expect a loss ratio of up to 20%.

Indeed, private equity is an opaque asset class compared to publicly-listed securities, although schemes with larger allocations have greater access to information about the companies in which they invest.

However, investors often accept higher risk, expressed in terms of capital loss or failure rate, in venture capital because they are also hoping returns will be higher, counters Bonheim. “If you go by the way of buyouts, you will also have to be willing to accept a higher level of risk as typically a buyout company will end up having more leverage on its balance sheet,” he says.

A wall of cheap debt since the 2008 financial crisis has buoyed the leveraged buyout industry, which should reverse once interest rates begin to rise. Buyout activity might constitute providing funding for management buy-outs, buying a spin-off division from another company, or taking a large interest in expanding entrepreneur businesses.

Yet with record amounts of “dry powder” being raised, can schemes expect the same level of returns in years to come? Competition for quality investments is rising. The question is whether private equity fund managers are at risk of over-paying for assets or if investors can still gain access to private investments that stand a chance of generating sufficient returns to compensate for the illiquidity and higher risks associated with the asset class.

“One of the big challenges for investors in private markets in 2020 is valuation because there is a tremendous amount of money going into these areas,” says Sven Smeets, co-head of private markets at Kempen Capital. “That is especially true of the biggest companies.”

Admittedly, the number of private equity vehicles is increasing, with a record 3,524 funds by the end of January. “The investable universe of assets, and hence the total value of [private equity] assets is growing, because many companies are choosing to stay private for much longer given the abundance of funding in the private markets,” says Bonheim.

However, there are some indications that competition and rising deal values are already starting to stymie market activity, as fund managers attempt to avoid overpaying for acquisitions. Between 2018 and 2019, the value of all private equity-backed buyout deals fell around a fifth to $389 billion, according to research from Preqin, while venture capital deal value declined by 18%, from $271 billion to $223 billion.

Small- and mid-cap companies may provide better opportunities for returns, as deal valuation multiples have not risen to the same extent as the larger end of the market. Within the European buyout market, deals valued at below €500 million were completed at an average EBITDA multiple of 7.7 in 2018, according to data from Adveq, compared with an average multiple of 11 for those above €500 million.

Investors may be encouraged by past performance. The LPF 50, which represents the returns of the biggest 50 private equity companies globally, has outperformed the MSCI World every year since 2014. However, the key metric used by private equity firms to report their performance is the internal rate of return (IRR), the net return earned by investors over a certain period, calculated on the basis of cash flows to and from investors, after the deduction of all fees, including carried interest. On that basis global private equity generated a median annualised net return of 17% over the three years to June 2019, according to Preqin.

Yet, most fund managers believe the market is going to become more challenging, with 62% – as well as 61% of investors – believing that the market is currently at the peak of the cycle, according to a survey by Preqin. That could mean that schemes will need to moderate their returns expectations going forward and cast a more critical eye over the fees they are being asked to pay, relative to the performance of their private equity investments.