Investors Remain Loyal to PE, Study Finds, But LPs Will Be More Demanding on Terms

Despite a shell-shocked global economy, a strong majority of limited partners plan to continue their steadfast commitments to private equity, with 83 percent saying they will maintain or increase their allocations to the asset class in the coming year, according to a closely watched study by Coller Capital on investors’ attitudes and plans.

And, in what could be a silver lining to the ongoing financial crisis, 68 percent of North American investors in the survey believe that 2012 will be a “good” or “excellent” vintage year for private equity, as firms and investors seek value amid the rubble. Tellingly, no respondents wager that 2012 will be a “poor” vintage.

The feeling of optimism extends even to European private equity, where 80 percent of LPs plan to maintain or increase their European exposure despite the ongoing sovereign debt saga afflicting the likes of Greece, Ireland, Italy, Portugal and Spain.

“Investors see considerable challenges out there, but they are optimistic,” said Jonathan Gutstein, a partner at Coller who helped analyze the data. “At the core, there is a belief in private equity as an asset class,” he said.

Coller’s “Barometer” survey asked detailed questions to 107 limited partners, including public and private pensions, insurance companies, endowments, foundations and family offices. Two-fifths of the limited partners were from North America; another two-fifths were in Europe, and one-fifth were in Asia. Forty percent of respondents managed at least $10 billion in assets.

Yet bullish expectations won’t translate into easy times for fundraising. After piling into private equity prior to the 2008 financial crisis, LPs have become more conservative on allocations to the asset class. For those who are putting money into private equity, it commonly comes with more strings attached.

“They have the leverage in this fundraising environment to say to general partners: You have to shift the balance back a little bit more in favor of limited partners,” says Frank Morgan, partner at Coller.

Morgan says guidelines adopted by the Institutional Limited Partners Association are increasingly factoring into fund terms.

“Many investors are staying the course, but with less capital available to invest,” said Gutstein, who said despite steady investor enthusiasm for private equity, the new money now being committed to private equity pales in comparison to amounts that were raised before the credit crisis began in 2008. And, because there are now an increasing number of funds in the marketplace, there is a heightened level of competition for that limited capital.

Rising competition is likely to have multiple consequences, including more favorable investor terms, smaller fund targets and a greater proportion of investors deciding not to “re-up” with successor funds, the survey revealed. “There is a supply and demand issue here, and as a result, LPs continue to expect to see terms and conditions that are more favorable to them,” said Gutstein, citing survey results which say that 80 percent of investors predict that terms will continue to become more favorable to them as a result of the downturn.

In addition, 93 percent of investors expect to reject at least some re-up requests, according to the report, and the typical LP is likely to reject at least a quarter of its re-up requests. Among re-up requests that are granted, 68 percent of investors plan to reduce the size of at least some of those new commitments in the next 18 months.

The survey also reflected investors’ increasing avoidance of large buyout funds (those seeking deals of $1 billion or more) and their growing affinity for small-cap and mid-market buyout vehicles. Investors, the survey reveals, are almost 10 times as likely (32 percent versus 3 percent) to decrease their exposure to large North American buyout funds as they are to increase their exposure to them, the report said.

On the other hand, investors are more than three times as likely to increase their exposure to North American small market private equity funds (37 percent versus 11 percent) as decrease that exposure. Similarly, investors are more than three times as likely to increase their appetite to the North American middle market (32 percent versus 10 percent) as they are to decrease their exposure.

Finally, the survey revealed some interesting statistics on “zombie funds,” funds that have no likelihood of earning carried interest, but which stay active to earn annual management fees. The issue represents an intractable challenge for most private equity investors in the survey, nearly half of whom have such funds in their portfolios. The survey found that 94 percent of investors believe they will not be able to find a way to eliminate the zombie fund stakes in their portfolios.

Joanna Glasner contributed to this report.