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Institutions shift towards Europe

There is no doubt that the experience of the last few years has affected and informed the investment decisions of European and US investors. So what are their thoughts on private equity? The results of a new AltAssets survey highlight a shift away from the US and from venture capital and towards European buy-outs. Chris Davison reports.

The intrinsic opacity of the private equity asset class makes it difficult to measure changes in investor sentiment with any accuracy. Things take a very long time to happen and there is only the partial visibility afforded by announced fund closings. That means trying to divine patterns from occasional events and the hearsay of fundraisers. This is compounded by the wildly contrasting strategies of the different institutional investors, themselves the product of different motives, expectations, and understandings about the asset class. All in all, any ambition to understand private equity's investors is muddled by an inefficiency that mirrors one of the chief drivers of the asset class' potential to outperform. The result is a wealth of guesswork, speculation and highly reactive decision-making among private equity firms planning their medium-term fundraising strategy.

This year's LP Perspective, a survey of 100 of the most active North American and European institutional investors in private equity, puts some substance on the anecdote and maps out the most important changes that have emerged over the last two years. The overarching theme is how institutions have entered the later stages of adjusting their strategy to reflect the experience of recent years, broadening their range of investments both by sector and by region. The two most distinctive developments beneath that umbrella have been the sharpening focus on Europe and a diminishing appetite for risk - the shift from growth to yield that echoes patterns more starkly evident across other asset classes.

The survey found institutions were planning a big move towards Europe, in particular its mid-market, which will see funds in the region expanding their share of total commitments to around 30 per cent over the next five years from the present level of around 25 per cent. US funds will see their share drop to around 60 per cent from the current level of 65 per cent. More than a third of North American institutions and almost a quarter of all European investors said they had increased their commitments to Europe over the last two years and the trend is expected to continue. The reasons? European buy-out returns over the last decade have exceeded those from the US and are expected to hold onto that premium for the foreseeable future. Its economies are judged to be ripe for the sort of restructuring and corporate dismantlement that produces the richest opportunities for private equity firms. The US, by contrast, is considered to have emerged the other side of this phase, and to be overpopulated with buy-out firms and thin on interesting deal flow.

The leading indicator for this development has been the appearance of the giant US buy-outs in continental Europe in recent years. KKR, Texas Pacific, and the Carlyle Group have confidently squared up to their European rivals over some of the biggest deals, eager to show their determination to muscle their way into the market. Now it is the turn of the institutional investors to recognise the opportunity and act on that confidence. Taking into account the overall increase in allocations forecast by respondents, the proposed changes in strategy would mean European funds receiving more than twice the US share of new capital over the next five years. The sample alone is expected to account for an extra $7bn of capital targeting new European funds and only $3bn extra for US funds. The challenge now is for aspiring European fundraisers to work out how they can access that North American capital.

Trend two, the diminishing appetite for risk, has been just as conspicuous. There has been a clear shift over the last two years away from venture capital towards what are perceived to be the safer segments of the asset class. About 25 per cent of institutions in both regions said they had cut their venture exposure over the last couple of years, while nearly a third had increased their allocation to buy-outs. Some of this move reflects disillusionment bred of the technology bubble experience but some of it belies a feeling that growth prospects across the board, from IT to consumer sectors, will be limited over the medium term. Hence the attention to yield. Buy-out firms, for example, have been responding with more cash flow-oriented investing. Some of that is about increasing the capacity to leverage the investment in a difficult debt environment. But some of that is also about being able to pay dividends - think yellow pages investments - or recapitalise entire or pieces of the portfolio. Any sort of distribution is better than nothing in the present climate.

But the ultimate example of private equity investors focus on yield rather than growth has been the burst of interest in mezzanine over the past 18 months. Nearly a third of the survey's respondents said they had increased their allocation to mezzanine over the last two years, making it the most pronounced change in their investment strategy. Mezzanine presently accounts for a little under four per cent of the average portfolio but is expected to reach almost six per cent over the next five years. These are small numbers but they represent a share of a very big number - more than $100 bn. Mezzanine firms in both North America and Europe have already experienced a gentle improvement in their fundraising over the last 12 months and that can be expected to continue over the medium term even if it falls some way short of becoming a deluge.

This second trend, the shifting emphasis on yield, has clear parallels with other asset classes and it may be that it has lessons for private equity further out on the horizon. The last couple of years have seen institutions move out of equities and into fixed income products. The modest treasuries bubble was the most obvious corollary. But even within fixed income there was a move away from risk, as evidenced by the collapse of high yield issuance in Europe. Sometimes it is called a flight to quality. Other times it is a run from risk. Changes in private equity have lagged these developments in public markets, mainly because the illiquidity of private equity makes it much more difficult to make rapid adjustments to strategy. But that lag may be instructive for looking ahead. Public equity markets have begun to stage a recovery, unremarkable but built on what increasingly appear to be solid foundations. There is even some believable talk about technology IPOs. The treasury bubble has burst. High yield issuance is showing a twinkling of life.

If there is a predictive relationship between other asset classes and the appetite of private equity investors then the themes of the next two years may not be the simple extensions of the last 18 months. Growth, albeit not quite of the steroidal variety enjoyed in the late 1990s, may swing back into fashion. Venture may cease to sound like a curse. Buy-out firms may rediscover more traditional strategies. The reopening of exit channels, whether IPOs or trade sales, signals an expectation of growth. Assuming this is not just smoke, next year's survey may suggest a less defensive mindset on the part of private equity investors, shifting back from their unusual dalliance with yield. It may even have implications for Europe's present popularity.

Chris Davison is head of research at AltAssets

The report, The Limited Partner Perspective: A Survey of North American and European Institutions 2003, is now available. Please click here for further details and to purchase.