As this news service observed from recent figures, private equity currently has something of an indigestion problem. As thoughts turn back from politics to subjects such as interest rates, SEI, the US investments solutions firm, offers its views.

Last week this publication noticed that the global private equity industry, which in some ways has prospered vigorously in recent years and brought in large inflows, has a bit of an indigestion problem (see that article here). Family offices and private banks have been urged to consider private capital of all kinds, and with traditional listed equity and bond markets not always proving to be happy hunting grounds, this is understandable. One of the organizations quoted in the report on sector indigestion was SEI, the US-headquartered investments firm. This news service interviewed Ross Ellis, vice president, investment manager services at SEI, to go into more detail about the private equity landscape. He touches on experience not just in the US. 

Are there challenges for private equity firms deploying increasing amounts of capital from institutions? How can and should they manage expectations?
Industrywide, capital distributions are exceeding the amount of capital called up. Confidence in the asset class remains strong and institutional investors appear to be planning on increasing allocations over the short and long-term. The amount of capital called up by private equity managers has been decreasing at the same time that the amount of dry powder in the market has grown, now heading towards $1 billion. Valuations are increasing as well. This means that the level of interest and demand in the asset class is outpacing opportunities, making it harder to meet years-prior IRR expectations.

Private equity offers a different risk profile than public equity so tempering an investor’s return expectations with non-correlation and other benefits needs to be done at the outset (and repeated throughout the vintage). Preqin [the research firm] analysis showed that a manager’s past performance is the #1 criteria by an institutional investor in private equity. Going into a market where the possibility of sub-standard returns (vs expectations) is high, uneducated buyers could end up with disappointing results (and their capital tied up for five-seven-nine years).

What should the industry do in manage this shift in investor demand? Do you see any effect on fees and remuneration for private equity firms as a result?
Many institution’s investment arms don’t have significant PE expertise and may not be able to appropriately distinguish the pro/cons of the asset class to public equities or fixed income. As investors may not therefore ask all the appropriate revealing questions, it would behoove a manager to proactively provide a higher level of transparency into their investments. For some investors, it would also be helpful if the managers could provide a degree of ongoing education on a strategic and portfolio level about the asset class and what they are seeing in the market.  This is more important as the term “private equity” also may include private debt, infrastructure, real estate etc., each one having its own nuances and risk/return characteristics.

ILPA has been recommending common reporting standards for the industry - and whether they are the right ones or not, the direction the association is heading is one that should help “professionalize” the industry while also educating the buyer.  Invest Europe (formerly EVCA) and other industry associations could become more (pro-) active and help educate the institutional investing community.

Investors (ought to) know that private equity is illiquid but, as was the case in the financial crisis, the severity of illiquidity or fire-sale pricing wasn’t appreciated until it forced investors to make very hard decisions. Managers and investors need to do due diligence on each other to ensure (as best they can) that the expectations are aligned.  Oftentimes this means having a manager help an investor understand how the PE investment fits into the investor’s overarching portfolio holistically, how having some illiquid holdings are okay and optimal from an asset allocation standpoint as long as there are liquid buckets to use in capital crunches.

Fees across the board seem to be falling, 2 & 20 [per cent annual management fee and performance fee, respectively] is more of a starting point or wish than reality.  But at the same time, there can be some bargaining if the manager is providing a significant amount of extra education and portfolio transparency.

There’s a regulatory wrinkle too that is happening in the US, but I am not sure it has gained ground yet in the UK.  If a university endowment, charitable foundation or corporate pension plan, the institution is investing for the ultimate benefit of students, teachers, police officers, etc., some of whom are saving for their own retirements.  As such, retail investors are actually invested in private equity (and hedge) funds. If there were unexpectedly low returns, fraudulent activities, etc., they would be hurt yet they aren’t in a position to protect themselves.  In the increasingly regulated world where perhaps the ‘retail” standards are beginning to be applied to an institutional product, private equity managers need to “cross every t and dot every I” much more attentively.

What dangers do you think there may be in terms of valuations, particularly if there were to be a rise in interest rates and effect on leverage?
Valuations have been increasing at the same time as dry powder.  As there is more demand and more capital but fewer transactions, the ability to source deals will become increasingly important. The gap between top decile/quartile funds and the bottom has been widening over the past decade, so allocating to the PE sector generically isn’t necessarily a sure-thing - manager selection is critical. Clearly as rates rise and leverage becomes more expensive, transactions achieving targeted returns within expected timeframes become even more challenging. Given the large amount of dry powder, that should minimise the full effect of an increase in borrowing cost in the short-term.

But there are always two sides of the transaction - if valuations increase, there will be an abundance of sellers, some of which may offer appealing or compromised terms - if valuations fall, then the opportunity to pick up deals increases (esp. as there is so much dry powder).  If the transaction involves renting, then the increase in rates would affect the cap rate and more often than not, this increases the value of the property. 

So, bottom line, an increase in rates is not always a negative for investors.