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Why long term investors are investing in private equity

Marta JankovicBy Marta Jankovic on 30 October 2017
Why long term investors are investing in private equity

Invest Europe’s latest data shows that last year European private equity raised €74 billion from investors. Invest Europe’s Chair, Marta Jankovic from APG, looks at reasons behind this strengthening appetite for private equity and discusses the issues investors need to consider.

Last year, European private equity fundraising increased by almost 40% to the highest level recorded since 2008, according to Invest Europe, demonstrating an asset class in strong demand. Pension funds directly accounted for over a third of the money raised, followed by funds-of-funds at 18% – these are often used by smaller pension fund managers that want to access private equity.

Why are these long-term investor groups allocating more to private equity? As a starting point, it is one of the few sources of superior returns. UK private equity funds – many of which invest on a pan-European basis – achieved annual net-of-fees returns of 14.1% since inception to 2016, according to the BVCA. This is significantly better than the 10.1% achieved by the FTSE All-Share index.

Pension fund managers already investing in the asset class also strongly believe it has the potential to outperform public equities in the future. More than three quarters of European pension fund managers surveyed in a 2014 Greenwich Associates report on European pension fund investment programmes and referenced in Invest Europe’s recent Guide to Private Equity and Venture Capital for Pension Funds said they expect private equity returns to surpass the public markets by 3% or above per year. The research revealed that 62% of pension funds already had a private equity programme, while a further 33% were setting one up.

Another positive aspect of private equity is the long-term nature of the asset class, which makes it less volatile than other investments and allows it to continue to deliver returns through market downswings. More importantly, this long-term horizon makes it highly attractive to pension funds, providing a good match for their liability profiles, which can stretch many decades into the future.

However, the landscape is not uniquely positive and there are some potential concerns that could impact demand for European private equity over the coming years.

First, new challenges to private equity’s model have arisen directly as a result of the asset class’s success. Fundraising levels have continued to grow year by year, putting the industry in a position where it now has a record amount of dry powder. This is not an issue in terms of exits, which naturally perform well when there is large amounts of capital chasing deals. However, it does give GPs more problems when trying to acquire businesses at attractive prices, and this could impact returns from investments being made now. Private equity acquirers accordingly need to avoid the temptation to put money to work at any price, and use their expertise in origination to find hidden gems and under-valued companies, where their operational skills can be used to create value.

Fortunately, having invested and grown companies through periods of economic turmoil, private equity fund managers are adept at identifying sectors or regions with growth potential, and at helping companies access new and expanding markets. As an example, last year, portfolio companies based in Southern Europe attracted more capital than those in the normally dominant region of UK and Ireland, driven by investments in Spain and Italy.

Another concern of pension funds has been that of transparency. It is the role of organisations such as Invest Europe to work with its 600 investor and fund manager members to increase focus on this area. The association’s Professional Standards Handbook is regularly updated by its members and includes best practice recommendations for investor reporting, fee transparency and ESG integration throughout the lifecycle of a fund.

Responsible investment continues to grow as an area of focus for private equity, with research in 2015 by PwC showing that 88% of limited partners believe there is added value in responsible investment, and 97% saying the area will increase in importance over the next two years. Recently, Invest Europe launched an ESG due diligence questionnaire as a practical tool to aid GPs in reviewing and monitoring portfolio companies, which garnered a lot of interest from the industry. It could also be adapted for use by LPs when assessing the ESG risks and opportunities of co-investments.

While the considerable challenges of economic uncertainty can affect private equity investments, the asset class is highly adaptable. In all market conditions there can be investment opportunities for fund managers across Europe, from corporate carve-outs to family-owned enterprises seeking more capital and management expertise.

As with any type of investment, it is important that pension funds are fully informed about both the possible upsides and downside of private equity. But with attention and due diligence – and by leveraging the expertise of Europe’s private equity fund managers – it is possible to build investment strategies that deliver excellent risk-adjusted returns over the long term.

First published in Pensions Expert.

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