The troubles pension funds and other institutional investors are having with their private equity (PE) portfolios have been making headlines, and regulators are reacting with more oversight. There is talk of diminished PE returns and a broken PE business model. Nevertheless, some industry experts still see potential in private equity, albeit with a healthy dose of applied knowledge and understanding of the asset class. One of them is Thomas Meyer, Director and Co-founder of LDS Partners, Luxembourg, whose company serves up methodologies and alternative asset management systems to Sovereign Wealth Funds, pension funds, fund of fund managers and DFIs. Thomas Meyer is also the author of Private Equity Unchained and Beyond the J-Curve.The following is a digest of our interview.
The potential of private equity lies in driving change in industry, driving adaptation and innovation. Change is associated with inefficiencies that provide potential for outperformance.
#1: Adapt the Change Mindset
Even with about USD 200 bn a year flowing into private equity, Thomas Meyer says the potential is still untapped. “The potential of private equity lies in driving change in industry, driving adaptation and innovation. Change is associated with inefficiencies that provide potential for outperformance,” said Meyer.
Private equity has the potential to transform and create value through innovation and adaptation. “The capital has mainly flowed into transactions that are close to public markets and operating in a similar environment,” said Meyer, referring to a cause of underperformance. “Driving change requires a mindset on the investors’ side to want change and invest in change,” said Meyer.
#2: Stop Overestimating Risks
Institutional investors are not necessarily exploiting the full potential of private equity because they are not measuring risk properly. It leads to overestimating risk and missed opportunities. They end up either making too small an allocation to private equity or creating unbalanced private equity portfolios.
An unbalanced portfolio happens when LPs focus on short-term risk measures like market risk. “LPs end up imitating too much what other market players are doing. This leads to portfolios that time the market and are exposed to the ‘flavor of the day’ at the time,” said Meyer.
Once they decide to make an allocation, investors need to have the right-sized team. “Providing training for staff, incentives and a career path are also essential. Typically, the private equity team is understaffed and without a sufficient budget for internal research and training,” said Meyer.
#3: Don’t Expect Scalability from GPs
Investors often do not understand the nature and supply of PE opportunities, particularly the limits to its scalability. PE is not necessarily scalable. “There is a relationship between a general partner (GP) fund size and returns. The data shows that returns will increase to a certain size of fund and then decline after a certain size,” said Meyer. The conclusion is that PE works best with a strong involvement of the general partners in each portfolio company’s growth trajectory.
Size matters. PE fund managers can get too big. “Some of the large mega buyout funds are more like public market entities with similar returns, which kind of misses the point of having PE in the portfolio. It is supposed to deliver outsized returns, higher than public market equivalents,” said Meyer.
#4: Use Decision Support Systems
Private equity has the potential to make a positive impact on the performance of a limited partner’s alternative asset portfolio, but risks cannot be measured using the same tools or approaches used in traditional portfolio management, according to Meyer. They need decision support systems. “It is not just a matter of monitoring and reporting,” said Meyer.
There are decision support systems available off the shelf. Meyer’s company provides one of them, with eFront as the technology partner. The alternative is to use an in-house system, which are typically built on spreadsheets, according to Meyer.
The PE market is illiquid, intransparent and the databases used for decision-making are imperfect. But that does not mean risk cannot be calculated or factored or mitigated. “There is risk in private equity investing but it is misunderstood. It is actually much lower than perceived provided that liquidity risk is kept under control,” said Meyer.
#5: Go after Right Sized LPs
Meyer sees mileage in David F. Swensen’s Yale model, which consists of dividing a portfolio into five or six roughly equal parts and investing each in a different asset class. “What is known is that the endowment model is where private equity returns have had a huge impact on the portfolio,” said Meyer.
Particularly well-suited for that model are medium-sized pension funds and institutional investors, if they have the expertise and sophistication. Family offices have the sweet spot in terms of size and they often have developed sophisticated teams. In theory, the larger ones are well-suited for private equity however Meyer says that they may be more interested in a hands-on approach which a fund of fund model is not the right instrument for. He also cautions that family offices can be too small, particularly during a downturn they may struggle to answer capital calls.