It is now over a year since opinion polls testified to the interest of international institutional investors in private equity. This demonstrates the growing doubt amongst pension fund managers about the ability of traditional asset classes to generate returns sufficient to cover their liabilities. In June 2011, Private Equity was credited amongst the institutional investor community with a net balance of investment intentions of 20% over the next three years. A new survey conducted by bfinance in November 2011, however, gives us a glimpse of the disappointment awaiting investors. The cause is their tendency to set high performance targets for new private equity investments, both compared to returns from the asset class in general and to that of their former partnerships in particular.

Source: bfinance, Private Equity Survey, 2^nd edition, November 2011

Source: bfinance, Private Equity Survey, 2^nd edition, November 2011

Although over half of investors (54%) invest in private equity through a special programme built up over time with several General Partners, a large swathe of institutional investors currently handle this asset class in an unsophisticated way (32% using an opportunistic approach and 15% rely on aggregators by investing in funds of funds). Moreover, in selecting their managers, investors place most importance on the quality of the private equity firm's investor base and reputation. These two criteria are of the sort that encourages herd mentality. However, from experience, channelling too much new investment money to a single manager or to a given strategy generally results in a lower level of returns. According to Preqin, at the start of December 2011, the amount of private equity fund capital committed, but not yet invested, stood out $900 billion.

Although the risk tends to be towards lower returns, the respondents to our survey set targets for their new investment returns that were on average higher than those of the performance of their former partnerships. This was particularly the case for investments in venture capital and special situations. Conversely, past returns from debt and buyout strategies came out, at the investor level, noticeably more in line with their future expectations.

For investors who invest in private equity opportunistically, this finding constitutes a strong rationale to invest in private debt in order to meet their performance expectations.  Indeed, the expectation of significantly lower return from these debt/mezzanine strategies deserves to be re-examined from the angle of lower dispersion in performance: 800 basis points between the net IRR of top quartile funds and third quartile funds (for a median return of 8.8%), against a range of over 2,000 points for venture capital strategies (median return of 6.4%) and a range of 1,800 points for special situations (median return of 13.6%), according to Preqin.

Source: bfinance, Private Equity Survey, 2^nd edition, November 2011

The survey carried out by bfinance looked at investors’ approaches to private equity. It turned out that many institutional investors relied entirely on their manager's reporting system. There was little attempt to negotiate better terms to achieve a higher return on investment, and they generally adopted a ‘hands off’ approach to their private equity portfolios.

Source: bfinance, Private Equity Survey, 2^nd edition, November 2011

In fact, 54% of respondents said that they monitored their investment solely on the basis of reports issued by their investment managers. This proportion exceeds 65% among institutional investors with less than $5 billion in funds under management, which represent almost half of the sample of respondents (20 out of 41).

Among respondents with assets of over $5bn, only 40% rely on fund managers’ reports and 30% seek third party assistance. This indicates that larger investors are more likely to have the resources necessary to actively manage their portfolios and managers. By doing so, each investor, irrespective of its size, maximizes the chance of spotting problems early, and solving them, whereas simply waiting and holding can cause declining returns.

There is a similar key difference between small and large investors in terms of the strategies used to improve returns through the terms of their partnerships. Unfortunately, most small investors tend to rely on ‘voting with their feet’ by investing in attractive managers, with 43% stating this as their preferred strategy, or on managers who follow ILPA principles (38%). In the short term, this passive behavior drives a lot of capital into funds offering less favorable terms to Limited Partners. Only 14% of respondents with assets up to $5bn negotiate improvements in their commitments through side letters.

By contrast, 40% of larger investors (with assets over US$5bn) negotiate improvements in commitment terms via side letters, while only 20% adopt a ‘vote with their feet’ strategy. 30% of these larger investors focus on partnerships that follow ILPA principles. This suggests that larger and sophisticated investors are better at negotiating to maximise value from their private equity managers.

Source: bfinance, Private Equity Survey, 2^nd edition, November 2011

In order to manage the risk and oversee liquidity in their portfolios, a majority (56%) of investors focus on achieving diversification at fund level, through a blend of vintage years and manager strategies. This is the preferred strategy for both large and small investors, although it is notable that 35% of investors with over $5bn of AUM prefer to dynamically adjust new commitments to maintain diversification targets at company asset level. This compares with only 5% of smaller investors who adopt this strategy. Again, this indicates that small investors tend to be passive, whilst larger investors are more active.

The secondary market provides just such an opportunity to manage portfolios dynamically. That said,  only 7% of investors (10% of larger investors, 5% of smaller ones) do side deals with secondaries or co-investments outside the direct fund commitment. 56% of investors find secondaries or co-investments attractive, but feel they are more easily accessed through a specialist fund of funds or an adviser. At a time of market turmoil and poor returns, private equity represents a valid opportunity to achieve diversification and enhanced portfolio performance. But this is contingent upon investors adopting a reasoned and well thought out strategy. 90% of investors feel that customised portfolio investment (CPI) is a logical step for investors seeking to improve transparency, control  and improved terms from their investments.

This e-mail address is being protected from spambots. You need JavaScript enabled to view it / This e-mail address is being protected from spambots. You need JavaScript enabled to view it

bfinance Pension Fund Asset Allocation Survey, June 2011

Survey details

Just under half of respondents (49%) have less than $5bn assets under management, about one in five (22%) have $5-10bn, and nearly a third (29%) have over $10bn. The majority of respondents are either portfolio/AUM managers or investment directors.