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As the global economy changes and shifts, shockwaves are being felt all through the world’s stock markets and much of that volatility is vibrating down to private markets. That’s not to say that there aren’t some significant opportunities in private equity, but the big money is being cautious. Holding more cash is the current economic reality.
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“Private equity fund managers have been actively taking advantage of the favourable fundraising environment over the past few years while several have raised funds but not activated them,” says Dr. William Charlton, Partner and Head of US at Altius Associates. “Thus, the private equity industry is in a somewhat unique situation in which private equity fund managers have a relatively easier time raising capital than they do in deploying it.”
In turn, private equity managers and leaders of private equity companies are struggling to deliver the sort of returns that commensurate with the level of risk these investments present. This changes the sort of investments you are going to see in private markets.
Looking Abroad at Private Markets
European private markets are a great example. Deal volumes there are back to the same level they were in 2007 and 2008. Distributions are outweighing any drawdowns. Investors are finding that their access to top-tier funds and opportunities are limited. At the same time, many large, institutional investors are starting to take their portfolios into their own hands, creating investment competition in the private markets.
Asian markets are following a similar pattern – large amounts of capital are being invested in a few select private equity opportunities that have a strong track record and the right people involved. Smaller investors can’t get in on the deal, and they are left with only substandard options – the type that does not provide enough upside to compensate for the level of risk.
Competition for Private Market Investments
Investment competition “is particularly strong in Europe as an increasing number of mid-sized North American pension funds enter a market that has been, hitherto, the domain of the large institutional investors and the sovereign wealth funds,” writes Nicola Meaden Grenham, Ph.D. and Senior Adviser at Armstrong International. “Historically, most of these pension fund investors would have selected specialist funds through which to access investment opportunities. Today, those who can prefer to invest directly, meaning that each specific investment decision rests with the pension fund.” Gresham continues, “Larger investors can increasingly source the deals themselves and avoid paying any fees to investment intermediaries. This thesis is, of course, predicated on being able to find the right talent.”
It also means that the institutional investors who take matters into their own hands have to have the right talent in place to source deals, or they will feel the effects on their pockets. “A startling 58 percent of the senior financial-services executives stated their company had been unable either to initiate an important project or deliver on key financial targets because of ‘poor human capital management’,” says Gresham. “In the energy sector, 53 percent said they had underperformed forecasted growth for the very same reason.”
Private Equity Strategy Overload
There is also a secondary issue – strategy overload. Institutional and high-net-worth investors are being presented with a broad range of different private equity investment options. This represents a significant shift from previous years when investing in the private equity market was more about picking a superstar venture capital manager or examining startups that present buyout opportunities and finding the right buyers, and it draws focus away from the longer investment horizons that more private equity deals have in favor of quick turnarounds.
“Arguments can be made for the merits of these investment strategies and high-quality managers find the approach that fits best with their team, capabilities, and past success,” says Catherine Mountjoy, Partner at Altius Associates. “Longer terms can provide a complementary investment to traditional fund structures and may help limit some of the reinvestment risks faced by investors. While all of these innovations can be helpful in providing solutions to certain investors, they also increase the complexity of investing in private equity and may cause conflicts for smaller or less informed investors. It is important for investors to consider how a fund manager’s other business may affect their investment and to know the questions to ask when conducting due diligence on a fund opportunity.”
Private Credit and Private Markets
Access to credit is another issue. Leveraging deals, be it a buyout or acquisition, has gotten more expensive as interest rates go up. While the increase is marginal right now, by 2017 the effect will be measurable if not significant. Interest rate increases could have an impact on legacy portfolios as well as new issuances. Private markets will still present a significant opportunity for investors but finding the sort of breakthrough innovations that lead the highest returns is bound to be more difficult.
“Given that debt levels used by fund managers in companies have been higher for sponsored direct lending strategies, we expect the probability of potential issues at the company level to be greater for this type of direct lending strategy than for non-sponsored ones,” explains Elvire Perrin, Partner and Executive Director at Altius Associates. “For new issuances, the cost of debt will increase mostly in line with interest rates increase when rates go above the Libor floors. This means that borrowers will need to spend more capital servicing their debt, likely reducing capital investment and level of innovation.”
Real Estate as an Opportunity
Some advisors, like Ernst & Young, see a boom in real estate coming. They say that a moderate increase in interest rates by the Federal Reserve will increase the expense of starting new real estate projects and refinancing existing ones. EY also notes the risk of a selloff in real estate investment trusts (REITs) but they do not feel that property values will be threatened by higher interest rates. In contrast, they see “improving economies, record amounts of inbound capital (although such capital can quickly dry up), available private equity dry powder and a generally positive economic outlook for the US, which should drive demand for commercial and residential real estate.” Moreover, EY thinks that the presence of nontraditional lenders, like private markets and business development funds will present an opportunity for real estate developers.