Private equity: Long-term gains


9 Apr 2024

Institutional investors are driving the growth of private equity, finds Andrew Holt.


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Institutional investors are driving the growth of private equity, finds Andrew Holt.

Private equity within the institutional investment world continues to grow at a rapid rate. Many of the latest surveys show that pension schemes will either increase their allocation to the asset class this year, or at least maintain their exposure.

This appears to show that they are strongly convinced by the performance and long-term potential of the asset class.

But how are institutional investors approaching such investments and what makes them so attractive?

Christian Dobson, alternatives portfolio manager at Border to Coast, gives an insight into why private equity is very much on the pension pool’s agenda. “We have been making allocations to private equity funds for the last five years and it is an area we continue to see interest in from our partner funds,” he says.

Dobson adds that private equity is attractive to institutional investors for a number of reasons. “Beyond long-term favourable returns, it provides diversification versus public markets and other asset classes.”

He continues to explain that it can also provide access to fast growing companies. “This benefit is increasing as we are seeing companies stay private longer, supported by a growing private equity ecosystem,” Dobson says.

In the driving seat

Another benefit when compared to public equities, where investors typically hold a minority stake, a large portion of private equity transactions are buyouts where firms take control of businesses.

“This allows them to be responsible for driving value creation through using their industry expertise to transform the business,” Dobson says.

“Having control of businesses, as well as a longer-term time horizon, allows private equity managers to focus on strategic projects which may have less benefit for short-term earnings, but can drive long-term value. This can lead to favourable returns when businesses are exited,” he adds.

Richard Moon, head of private markets at Railpen, agrees that private equity is significant for institutional investors. “Private equity is the largest component of our multi-strategy private markets portfolio,” he says.

Aoifinn Devitt, chief investment officer of London CIV, is seeing a great demand for the asset class. “This reflects a trend around the LGPS and institutions generally, with the exceptions being defined benefit schemes which are in risk-off mode, but most institutions from small to large on a global basis are allocating more to privates. That is a trend we are participating in,” she says.

She does note though that some of London CIV’s clients are at different parts of their learning curve in regard to the asset class. “Some are well advanced while some are only dipping their toe on the water,” Devitt says. “Catering for them is going to be a priority.”

Meaningful ownership

For Moon, private equity has two big attractions. “It offers high returns and diversification to our public equity portfolio, particularly in the lower mid-market – £10m to £40m companies – where we are focused,” he says.

In addition, there is an added advantage in that governance is generally strong in private equity-backed companies, Moon adds.

“Management teams tend to be well aligned with private equity owners through incentive plans that enable meaningful ownership in the portfolio companies. In private equity, company boards tend to be small and focused, with industry specialists supporting growth and other value creation initiatives,” he says.

Eric Deram, managing partner at Flexstone, an affiliate of Natixis Investment Managers, also lists the benefits of private equity for institutional investors. “First and foremost, it is the superior performance over the long term against pretty much all other asset classes which attracts investors,” he says.

Other attractions include a low correlation with public markets; low volatility; the vastness of the opportunity set allowing investors to build diversified portfolios; strong alignment of interest between management, fund managers and their investors; and financing the real economy.

“At the end of the day, 80% to 90% of companies around the world – the backbone of every economy – are held in private hands, including the large ones. Private equity provides vital equity financing to these companies,” Deram says.

Barriers to entry

And for pensions funds there are other attractions. “Contrary to public markets, the private equity model enables management to take a longer-term perspective,” Moon says. “This enables portfolio companies to prioritise value-creation initiatives, irrespective of timeframe, such as capex, which may not show up in earnings for several years.”

John Eres, a fund manager in the private equity and impact division of M&G’s private markets business, says there is more mileage from private equity that investors can exploit, but other factors are contributing to a lack of commitment. “We believe it is an established asset class, which is under allocated in many portfolios because executing and managing private equity portfolios is challenging.”

Eres cites that over the last few years there has been a significant rise in interest given regulatory and technological change, but even against that backdrop, newer entrants to the space are mindful of the investment expertise, networks and operational platforms needed to execute strategies effectively.

“But given the increased regulatory pressure and expanding range of investment vehicles available, it feels increasingly incumbent on investors to consider whether allocations might be in the best interest of their stakeholders or clients,” he says.

Trend setters

Institutions on the other side of the Atlantic are long-time supporters of private market assets.

The reason, Eres says, are first investment principles. “By incorporating assets that have a low correlation to traditional assets and strong performance potential, they improve overall portfolio efficiency.”

However, this has been taken to an extreme through the endowment model, where illiquid private assets make up to half of the portfolio. “Such high allocations can be taken because they have a long-term view and enough liquidity from elsewhere in their portfolio to meet their near-term needs,” Eres says.

But the timing could be right for British institutional investors to take the private equity plunge, Dobson says. “Given fundraising challenges faced by many managers, this is a favourable time for institutional investors to be allocating capital to the space,” he adds. “Investors are able to be increasingly selective around the funds they make commitments to.”

It also means investors can negotiate access to managers that have historically not had capacity for new investors and can drive improved economics through fee negotiations. “Funds will often have completed seed investments which can be diligence by investors, reducing the blind pool risk of opportunities,” Dobson adds.

Made to measure

There are though other aspects of private equity that are not being discussed but should be from an institutional investor perspective, Moon says, citing the importance of measuring returns.

“Assessing private equity’s ability to generate attractive returns relative to other parts of private markets – such as debt – and public markets, lower leverage, in a higher interest rate/lower growth environment [is important],” he adds. “In response to this, we’ve improved the sophistication of our due diligence in assessing the various drivers of company-level returns.”

It has been argued that private equity is one of the purest areas of active investing, especially where controlling stakes are held, and managers can forge transformative change to drive value creation.

“This is often hands on, resource intensive work with managers who are highly motivated to grow businesses,” Eres says.

“Increasingly, we are seeing ESG as a core pillar of value creation as managers look out five years to what will make a portfolio company de-risked and attractive for future buyers. We see larger institutional investors investing alongside us with our preferred managers, but we also have conversations with more modestly resourced institutions,” he adds.

As with most investments there has to be a level of caution amongst the enthusiasm. A well-formed established private equity portfolio can generate attractive returns from a diverse range of sources, but the journey to build it takes time and commitment, Eres says.

“It is reliant on deep expertise – from strong networks to originate access to funds and co-investments, to nurturing new managers as they spin out of established houses or to background checking when you don’t have the same access to information that the public markets enjoy,” he adds.

There has also been an increased amount of consolidation within the industry. That could be a plus but could see private equity become part of a wider, multi-layered private market approach.

“We are seeing increased consolidation, as managers bring on teams to o er a collection of private market strategies – something that we have done for a long time at M&G, offering not just private equity but also real assets, private credit, real estate and infrastructure,” Eres says.

A dynamic market

But, as you would expect with a developing and growing market, there is a great deal of dynamism at play within the asset class. “As the private equity industry opens up, it is also becoming more dynamic with the evolution of co-investments, continuation vehicles [where assets are transferred from a fund at the end of its term into a new fund] and growing liquidity in the secondaries market not to mention new regulated investment vehicles,” Eres says.

“These developments are allowing for a more agile approach, but they do require expertise and understanding.”

Exploring ways to achieve value within private equity, Deram believes that there are three methods. One, use leverage, which was effective over the last 10-plus years with the cost of debt close to zero, but less so today.

Two, multiple expansion. “This can be the result of market swings, which cannot be controlled, or a significant improvement in the quality of the assets,” Deram says.

This latter point brings us to the third lever of value creation: operational improvement. “Some general partners have consistently generated value through this hands-on reshaping of companies’ approach for decades,” Deram says.

“Others are realising today that it is the only way to create value now that debt is expensive, to di erentiate oneself and to gen- erate consistent superior value. If a fund manager has the skills to reshape companies, he/she can do so over and over thereby generate sustainable superior returns,” he adds.

More than half of the value creation Deram says he has delivered to investors is through funds of funds, secondary and co-investment strategies. It has historically come from cashflow growth of the underlying companies, which itself is derived from the ability of the fund managers selected to drive operational improvements and ‘reshaping’.

Not for everyone

Of course, fees are a regular sticking point cited by some wary investors unwilling to take the private equity plunge. “One of the main debates about private equity within the institutional investor community in the UK is whether the performance fees are too rich for fund managers. For this reason, many do not invest in the asset class,” Deram says.

He does though state it is worth highlighting two points in regard to this scepticism. “One, private equity investing is an active, hands-on investment strategy. To be successful, one needs to employ highly skilled investment professionals.”

And the second point: “Private equity performance fees, unlike for hedge funds or other liquid investment funds, is only paid out to private equity fund managers after several years, and only once the capital gain plus a preferred return – generally 8% per annum – has been fully repaid to the investors. It is therefore subordinated to an 8% annual return to investors in most cases,” Deram adds.

All in all, the case for private equity is significant, and one that is difficult for institutional investors to ignore.


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