In light of the credit crunch and ongoing financial crisis I have often been asked if private equity is still a core holding for investors as deals dry up and performance reverts to the mean. My answer is that I do not agree with the premise of the question. While “mega” deal volumes have plummeted and overall deal activity has slowed, these levels continue to be high in historical terms and private equity fund raising is on track to set new records. Let us look at these elements in more details and build a thesis for the sustainability of growth in the private equity sector.
A Record 2008 for private equity fundraising
Newly released figures are pointing to a significant increase in global private equity fundraising for 2008. Venture Economics data show H1 2008 levels of $276bn (E188bn). Annualized ($552bn), this represents a 17 per cent increase over the 2007 levels, a record year, and a 59 per cent increase over the average of the past 11 years of $221bn per year. Other evidence corroborates these figures. Private Equity Intelligence and Probitas show fund raising for distressed and turnaround private equity funds through April of 2008 already equal to all funds raised for 2007. Furthermore, the Emerging Markets Private Equity Associations estimates that the $35bn raised in the first half of 2008 for emerging markets private equity represents a 68 per cent increase over the levels from the same period in 2007.
The data shows a slowdown in the growth of fundraising for mega funds and other private equity sub-classes in favor of distressed, turnaround, growth, mid-market and emerging markets funds, areas that investors perceive as having a better chance of deploying capital and achieving target returns in the current environment. The shift in allocation among the various private equity subclasses is logical and continuous calibration will persist as the norm in the long run based on prevailing market conditions. However, the key takeaway from the record fundraising levels is that we are in the midst of a structural shift towards increased allocations to private equity by both institutional investors as well as high net worth individuals.
Good return, downside resilience and limited volatility
The promise of private equity has been to deliver premium returns over the public equity markets - a compensation for the lack of liquidity of the asset class as well as the potential higher risk of some of the underlying assets depending on the focus of the fund (leverage for LBO funds, technology for VC funds, emerging markets risks for Asia funds, etc.). The reality has been even more attractive for some investors. Top quartile buyout managers have been able to achieve remarkable returns over the past decade. This fact is often trumpeted in conferences and pitches. Less discussed, but highly attractive are some additional factors that are propelling the witnessed growth in the asset class.
Private equity reported valuations tend to have low volatility, an attractive feature for many investors. The trend in accounting rules is for more frequent and more accurate marking-to-market of portfolio assets in private equity funds. While this may increase the volatility of reported valuations, it is likely to remain well below other asset classes. Part of the reason is that the compensation structure for private equity firms, which generates carried interest for the manager only upon cash realisations of the underlying investments, has resulted in an industry with limited incentive to write up valuations of portfolio assets.
David Rubenstein, co-founder of The Carlyle Group, often asserts that his firm has never sold a portfolio company at a price lower than the last reported quarterly net asset value. This is consistent with what we see in our business.
Furthermore, but less documented, there is a general belief by seasoned investors that diversified portfolios of buyout funds have shown resilience to “blow ups” and capital loss (this is not the case for venture capital, a segment that has performed poorly over the past decade).
Structural characteristics
From a structural perspective, private equity is very different from other institutional asset classes. These structural differences often hinder the growth of private equity as investors who do not understand them often shy away from the asset class. On the other hand, as more investors begin to understand these characteristics they often increase their allocation to private equity.
For most investors, private equity investments are typically made through closed-end funds that call capital when it is needed (to buy a company) and distribute profits as they are realized (once a company is sold). This characteristic has dramatic implications for levels of commitments by investors.
