Private equity investors worry about strategic drift

Three-quarters of institutional investors in private equity (limited partners or LPs) are worried that private equity fund managers (general partners or GPs) will stray into strategies or geographies where they lack expertise, according to the latest Global Private Equity Barometer produced by Coller Capital, a leading global investor in private equity secondary transactions. North American LPs see the danger as particularly acute – 84% of them perceive GP “strategy drift” as a risk to their returns.

Jeremy Coller, founder and chief information officer of Coller Capital, told Acquisitions Monthly: “We are living in interesting times. Institutional appetite for private equity is growing – at a time when the climate for GP investment has become trickier.

“This combination is rightly sounding warning bells among investors,” he says. “They know the dispersion of returns between more and less able GPs rises in tougher times, so worrying about GP ‘strategy drift’ and focusing more resources on their strongest managers are very sensible responses to today’s climate.”

Investors’ own growing appetite for private equity is partly to blame, of course: well over a third of LPs (38%) are planning to increase their allocations to private equity over the next year (with only 3% planning a reduction). Strong returns will also continue to attract new investors to the asset class, LPs think – four out of five existing investors expect a significant influx of new LPs over the next three years.

Investors surveyed by Coller Capital believe growing institutional appetite for private equity will increase the premium on LP talent – 77% of current investors see the market for LP skills becoming significantly more competitive over the next three years. Half of LPs even expect institutions to increase their recruitment from private equity firms as the “talent war” intensifies.

Investors see the best opportunities in private equity in the coming year in small and medium-sized European buyouts. The lower end of the buyouts market is expected to be attractive everywhere – especially for small (less than US$200m) and mid-market investments (deals of US$200m–$1bn).

In today’s climate, investors see the most attractive opportunities for private equity investment in sectors with long-term growth potential – healthcare and technology, for example. Sectors most at risk from economic downturn – such as real estate and consumer industries – are considered less attractive.

The prospect of a prolonged downturn is reflected, too, in a stronger preference for distressed debt. More than a quarter (28%) of Asian LPs and almost a fifth (18%) of European investors plan to begin investing in distressed debt for the first time in the next 12 months.

This surge in interest is explained by investors’ return expectations – half foresee returns of 16%-plus from distressed debt over the next three to five years. Plans to commit to this sub-asset class for the first time are less pronounced among North American investors, a far higher proportion of which (65%) are already invested in distressed debt.

Mezzanine debt, too, is expected to attract more first-time commitments in the coming year. The proportion of Asian LPs investing in mezzanine is expected to double over the next 12 months – from 17% to 34%. More modest first-time investment in North America and Europe will take LPs’ exposure to mezzanine in these regions to 50% and 63% respectively. Some 70% of LPs expect returns of 11%-plus from mezzanine over the next three to five years.

Investors are active buyers as well as sellers in the secondary transactions market. More than one in five LPs (22%) have sold assets as secondary trades, and one in three (35%) have bought assets in this way (excluding funds-of-funds.)

Although LPs think liquidity will be an important reason for selling in the next couple of years, their desire to focus on their best-performing GPs is expected to be an even more important driver of sales. LP usage of secondaries to rebalance their portfolios between types of private equity (venture and buyouts, say) is also expected to be a significant driver of the market.

Sovereign wealth funds (SWFs) are engaging with private equity at many levels, not only as investors in private equity funds – where their importance is still growing – but also as players in the market itself. LPs are divided about the threat SWFs pose to GPs, with 58% thinking they are, or are becoming, significant competitors to buyout firms. A large majority of investors (80%) expect significantly more strategic partnerships between GPs and SWFs in the next couple of years.