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Institutional investors in the dark over private equity return expectations

7 Dec 2011

There is a mismatch between long-term actual and expected returns for private equity strategies, according to a global survey of institutional investors by financial research outfit bfinance.

Institutions surveyed continue to see private equity as a critical source of return enhancement for their overall investment portfolio, but experiences varied from strategy to strategy.

Responses from institutional investors highlight a significant difference between expected returns from private equity strategies and the reality of realised net of fees returns in their portfolio. Institutional investors have adjusted their expected returns downward across most investments strategies facing a significant amount of capital uninvested, high competition for transactions and extended holding periods driven by lack of financing and liquidity constraints.

A notable exception is private debt strategies, whose past returns are the most closely aligned with future expectations and today often provide a better risk adjusted return than other private equity strategies.

The survey also found that 93 per cent of institutions set their private equity funds a performance target (net internal rate of return, or IRR) of over ten per cent, yet less than half generated an actual net IRR of more than ten per cent.

However, expectations and experience varies greatly by investment strategy. In terms of individual strategies, institutions considered expected returns from private debt investments as the most closely aligned with actual returns. Seventy-four per cent expected a net IRR of over 10 per cent and nearly 70 per cent achieved this.

Emmanuel Léchère, head of market intelligence group at bfinance, said, “Clearly private equity has a major role to play in enhancing overall returns but to align actual returns with future expectations, more institutional investors need to adopt a dynamic rather than an opportunistic approach to portfolio management that emphasises stringent management selection, monitoring and negotiation in order to maximise the potential of investments in this asset class.”

In contrast, investors’ sentiment on venture capital shows the largest difference between expectations and past experience with 87 per cent of all investors expecting over ten per cent net IRR and only 44 per cent of such investors having achieved ten per cent or above net IRR from prior venture capital investments.

Buy-out investment strategies are still attractive, although investors have reduced their return expectations. Eighty-nine per cent of all investors surveyed expect at least ten per cent net IRR from buy-out investments. Seventy-three per cent of investors have achieved these returns or above in past.

Special situations investments are highly attractive in moments of distress or volatility, with 97 per cent of all investors expecting in excess of ten per cent net IRR from these strategies. However there is some significant risk in manager selection as demonstrated by 24 per cent of the respondents having achieved less than ten per cent net IRR from these strategies.

Absolute returns is seen as the most appropriate benchmark against which to assess private equity strategies. Seventy-three per cent of all investors surveyed benchmark their private equity fund investments using net IRR and cash multiples against similar fund manager groups by vintage and strategies. Fifty-six per cent of investors have furthermore specified that they consider private equity as an absolute return asset class. Only seven per cent of investors compare private equity returns to inflation plus indices, and only 51 per cent of all investors compare private equity performance to public market performance plus a premium for illiquidity.

Eighty-eight per cent of investors identified ‘portfolio return enhancement’ as the first or second most important reason to invest in private equity. A similarly important rationale for investing in private equity is the ability to obtain returns from sources not accessible through public markets: Eighty-one per cent of all investors say this as the first or second reason for investing. In contrast, only 24 per cent of investors saw ‘risk diversification’ as being amongst the first two reasons for allocating to private equity.

Although 54 per cent of investors have a dedicated programme which gradually builds up their private equity investments, only 20 per cent have a tailored investment program that dynamically adjusts new commitments to maintain the diversification target at the underlying company asset level. This latter figure rises to 35 per cent if we consider the population of respondents with over $5bn in AUM.

Brand recognition and quality of the investors’ base were identified as important criteria for institutions when selecting a private equity fund manager. Over 56 per cent of all investors ranked brand recognition and 59 per cent of investors ranked the quality of the investor base of a fund manager as one of the top three reasons for investing in a private equity manager.

Only 46 per cent of institutions pursued additional verification of private equity managers’ reporting, with 54 per cent relying solely on the reporting provided by the fund managers. This trend was more noticeable amongst smaller institutions (AUM under $5bn) with 67 per cent relying solely on the reporting of their private equity managers to monitor their investments, compared to 40 per cent for larger institutions.

In order to manage the risk and oversee liquidity in their portfolios, a majority (56 per cent) of investors focus on achieving diversification at fund level, through a blend of vintage years and manager strategies. However the approach is substantially different between larger and smaller investors, 45 per cent of investors with over $5bn of assets under management prefer to dynamically adjust new commitments or invest opportunistically to maintain diversification targets at company asset level. This compares to 71 per cent of smaller investors who adopt the opposite strategy: holding a diversified pool fund of investments for maximum risk diversification.

Only seven per cent of investors actively manage their portfolios by doing side deals with secondaries or co-investments outside the direct fund commitment.

There is strong support for customised portfolio implementation, with 90 per cent claiming this is a logical step for investors seeking to improve transparency, control and improved terms for their own investments. However, when asked directly, most investors feel as if they have sufficient expertise to invest directly: just ten per cent of smaller institutions and 30 per cent of larger institutions noted the importance of advice and assistance from a third party in monitoring their investments.

Lorenzo Rossi, a managing director of private markets at bfinance, said, “This survey underscores the fact that investors should actively invest in private equity rather than simply allocating to it. Average returns in the asset class often do not justify the illiquidity and too often realized returns net of all fees fall short of expectations. Therefore Investors need to focus on selecting the right managers that can create superior absolute returns. Amongst these, investors should seek out those that are correctly aligned to extract value for investors rather than for themselves.”

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