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Institutional Investors Looking to Private Equity

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July 13, 2015

 

The private equity sector has been able to attract plenty of attention in recent years. One of the most recent interests has come from institutional investors, who are increasingly attracted to the sector that can offer better returns to many other traditional asset classes. But as regulatory oversight into the industry is increasing in places like the US, can the fund managers continue to meet the expectations?

 

Improved Returns

 

Institutional investors are undoubtedly lured into investing in private equity because the returns have been on the increase, especially compared to some other alternative asset classes.

 

In a recent Bain & Company private equity report, the company states that distributions in the Asia-Pacific regions have finally started to pick up. One of the best performing firms has been Permira. According to the Sunday’s Financial Times article, the private equity group has managed to pay back three-quarters of the capital it raised with its previous global fund.

 

In a Preqin report, majority of investors have high expectations for their private equity funds, although the trust isn’t completely at the previous levels. Furthermore, the Preqin data also shows that vast majority of investors have consistently had their expectations met in recent years.

 

Increasing Regulatory Focus

 

One of the biggest factors hindering private equity interest has been the focus, especially in the US, on the fee structures of the companies. Just recently, the US Securities and Exchange Commission (SEC) highlighted the need to continue reforming the legislation around the sector and diminish the instances of wrongdoing.

 

The biggest focus of recent months has been on the fee structure of many private equity firms, as well as various other fees the firms often charge clients. Any future changes in the legislation or regulations that focus more on private equity manager fees, the sector might have to look at the way it delivers return. This could naturally hinder the prospect of institutional investors continuing their investment focus on private equity assets.

 

SEC outlined its examination priorities for 2015 and said the fees to be at the forefront of any investigations. “Given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area,” the report outlined in January this year.

 

Furthermore, the notable cases that have seen private equity firms fined could well pose problems for investor appetite. KKR recently agreed to pay $30 million in fines to SEC, along with a $10 million penalty. At the time, KKR’s spokeswoman told the MarketWatch, “We take our fiduciary responsibilities seriously and have strived to adapt our policies and practices to the changing nature of the industry, market and our business.”

 

Other private equity firms are likely to have their operations looked at by authorities in the US and elsewhere in the world. Institutional investors, such as pension funds, have openly admitted being unaware of how they pay their private equity managers. According to the Financial Times, Calpers, the largest public pension fund in the US, has started to focus more on how managers are based, as well as reduce the amount of managers.

 

Concern Over ‘Dry Powder’

 

On the other hand, there is also the question of ‘dry powder’ in the sector, which is causing concern among institutional investors. According to the most recent data by Preqin, the global ‘dry powder’ levels have reached record-breaking amounts in the sector.

 

In its first quarter report, the research company said the global amount of ‘dry powder’ by private equity groups stood at $1.24 trillion. More worryingly to many investors, the figure has increased by 13% since the end of 2014. Real estate funds have seen the biggest rise, but buyout funds still have the largest proportion of ‘dry powder’ at 37%.

 

The worry among institutional investors is that fund managers will start overpaying for deals to get rid off this unallocated capital. Valuations have been going up, even reaching similar highs the sector saw prior to the financial crash.

 

Mark Calnan, global head of private equity at Towers Watson, told the Financial Times on Sunday, “It is important to be meticulously selective when choosing managers that have displayed pricing discipline.” Mr Calnan continued stating, “A key challenge is to be able to distinguish between the marketing claims every manager makes and those they can genuinely deliver”.

 

Focusing on Alternative Strategies

 

The appetite for hefty returns and the concern over the problems mentioned above have meant that many institutional investors are not sure how to reallocate their returns. This has led to new sorts of strategies.

 

As we’ve mentioned in our previous post, co-investments have been among the most attractive strategies the sector has implemented. Mr Calnan said in the interview, “Strategic partnerships, co-investments and longer-life fund vehicles are all evidence of an implementation revolution that we should expect to see develop further over the next three to five years”.

 

Institutional investor appetite is likely to remain strong in the coming years. PwC recently forecasted the private equity industry to grow its assets between $6.5 trillion and $7.4 trillion by 2020. This would be a massive increase in just five years, considering the current level is $3.5 trillion.

 

Much of the recent growth in fundraising is driven by the institutional investor appetite, especially in countries such as China and India, and it is likely the sector will continue to perform strongly.

 

Yet, most private equity firms have to be careful in the coming months in the way they respond to the concerns institutional investors have. A lot will depend also on the regulatory authorities. Mr Calnan said in the Financial Times interview, “Willingness to be transparent on fees and charges is something all managers should be comfortable with”.

 

It will be interesting to see what is the sector’s response to the increasing scrutiny, not only by the authorities, but also by the institutional investors.

 

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