Private Equity Firms Hunt Harder For Returns - CAIS

Tom Burroughes

9 April 2019

The decibel level around the case for investing in private equity continues to be high and this publication recently spoke to Nicholas Millikan, director of research, alternative investments at CAIS, a technology platform that gives access to such alternative assets. We asked about how far the private equity story can go on before there’s a need for a course correction, or whether the industry might have a digestion problem, and how the asset should sit inside portfolios.

The comments follow a number of ruminations about private equity in recent weeks. See examples here and here.

What are the main issues a client must understand in integrating PE into a traditional portfolio?
My belief is that the biggest issue clients must understand about private equity is its long investment period and the illiquidity that comes along with that. Many PE funds have a lifespan of 10 years, during which time investors have very limited access to their capital. However, it is over this extended period that PE managers seek to unlock value through their operations, so this is really a necessary structure to achieve the targeted returns. Additionally, the typical trajectory of the return profile, known as the J Curve can rattle investors. This is the tendency for PE to initially deliver negative returns in early years - due to the management fees, investment costs, and investments being held at cost initially - with potential for investment gains in later years as the underlying companies mature.

With that said, PE can help investors seeking an additional source of growth within their portfolio, as well as returns that are uncorrelated to traditional investments.

There is more than a $1.0 trillion of "dry powder" in private equity today - are valuations getting a bit stretched and how much real capacity is there left in the asset class? Is the sector robust enough to cope if the economy hits difficulty?
Valuations across assets appear to be on the high side given the recent economic expansion in the US. Adding to the issue is the amount of dry powder in the PE industry which could make putting capital to work more difficult. This is going to mean that just as PE managers are going to need to do their work to find the most attractive deals, investors are going to have to do their work to find the most attractive PE managers. PE is an “always open” market despite what is going on in the broader economy. It has generally adapted to adversity and from what I am seeing, there are already signs of this, specifically, PE managers are getting creative in how they deploy capital.

Another interesting point on this topic, is that the significant dry powder looking for deals should complement private direct lending funds. If the market was to fracture, PE firms may look to deploy capital into attractive valuations at the same time banks may not have the capacity to lend, therefore, giving private lenders a potentially attractive opportunity to deploy capital as well.

Are there sufficiently accessible PE funds out there for private client investors to tap into? Have the hottest managers already been filled up?
This may be the biggest issue facing investors seeking access to the highly exclusive PE industry. The largest and best performing managers are typically inaccessible, not only to retail investors, but even to larger institutions. From high minimums, to the oversubscribed nature of the best managers, investors may need to look to alternative vehicles, such as fund of funds to access the highest caliber managers.

What sort of investment minimums prevail at the moment? Are fees still relatively high or are there signs of pressure?
Investment minimums have come down in recent years but for the most part, PE is still only available to “Accredited Investors” or “Qualified Purchasers” which all but rules out much of the retail investor market. Innovation in product design and structuring continues amongst PE managers as they seek to diversify their client base and continue to charge attractive fees to a broader client set, most of whom have sat on the sidelines in recent years looking on as PE has delivered returns for their institutional investors and are willing to pay higher fees for access.

Which types of PE strategy make most sense at the moment or should an investor have a range? How else should an investor diversify: sector type, geography, type of manager, other?
As with all types of investments, I believe that diversification is key to achieving attractive risk adjusted returns. This could be in the form of diversified geographic exposure of PE managers, or in the strategies of the underlying managers. The high minimums and difficulty of access make diversification difficult. There are several solutions out there, such as accessing PE through a vintage fund which includes several different managers each year or ‘vintage’, or a fund of fund structure.

Any final points you want to make?
People are attracted to the PE market because of the high returns they have been able to produce over the past decade. This however, doesn’t mean that every PE manager is able to produce these returns. Next to venture capital, PE has the highest dispersion of returns between managers. Looking at analysis compiled by JP Morgan between 2013 and 2018, the best performing manager returned 21.5 per cent, while the worst returned just 0.7 per cent - a dispersion of 20.8 per cent. This means that manager selection is crucial to attaining the type of returns investors are seeking when they delve into the universe of PE.