Fortune favors the brave

The private-equity (PE) market has developed phenomenally over the past decade post the global financial crisis. It is estimated that total assets under management in private equity reached nearly $3 trillion in 2017, on the back of a strong fundraising environment, which saw private-equity firms take in nearly $2 trillion of investor commitments over the last five years.^[1] However, this remarkable rise hides four major trends in the market today, which investors would be wise to consider.

The first is that private equity has delivered very attractive returns. However, that has only been true for those investors sticking with managers (called general partners, or "GPs") through multiple cycles and having access to top-performing GPs. For example, the return variance between top- and bottom-quartile performances was well in the double digits, based on data from 2008 'vintage' funds. By now, such funds tend to be mature with relatively low future return variance. Investors in top-quartile managers have also enjoyed premium returns over relevant public-market benchmarks . However, for those in poorly performing funds, the returns did not always compensate for the comparative illiquidity of the asset class.

Talking about illiquidity, a second major trend is the remarkable recent growth in secondary buyouts. Historically, the private-equity market has been an inherently long-term, illiquid asset class, as evidenced by some funds taking over 19 years to liquidate. With the increasing prevalence of secondary capital in the market, investors (called limited partners, or "LPs") have been able to sell their stakes in private-equity funds, and have even been able to sell multiple portfolio companies at a single time, sometimes in transactions led by the private-equity-fund GPs themselves. It is estimated that around $125 billion^[2] of dry powder exists in this market, leading LPs to take advantage of the market climate by selling illiquid private-equity portfolios of up to $2 billion. Effectively, this has made the asset class itself more liquid. Furthermore, LPs have invested large amounts into private-equity funds specifically targeting secondary buyouts. This can offer instant access to a highly diversified private-equity portfolio; providing exposure across vintage years, sectors and geographies.

So where does the private-equity market go over the next decade? We don't see any imminent downturn in the level of fundraising. However, all the fundraising may have some unintended side-effects, driving a third major trend. More money allocated to private equity is causing fierce competition between GPs for quality assets, leading to higher purchase prices (financed mainly by equity rather than high levels of debt). In and of itself, this is putting pressure on returns, with GPs in the buyout space telling investors to expect lower returns (though these still look attractive in the mid-double digits).

Fierce competition should only reinforce a fourth set of cyclical and secular changes seen in recent years. On the cyclical side, LPs have been increasing asset allocations to alternative investments – and private equity in particular – as a means of diversifying portfolios. On the secular side, the prevailing theme over the last few years has been larger allocations to 'brand-name' funds, as LPs consolidate their relationships and commit additional capital to favored managers.^[3] Consequently, this market development has led to a highly competitive environment for smaller, newer managers which need to do more to prove themselves to investors than ever before. As a result, we believe manager selection – and having access to the very best managers – will become even more important in the next phase of the market's evolution.

The growth in fundraising reflects increasing asset allocations to alternative investments in general – and private equity in particular.

Source: 2018 Preqin Global PE & VC Report as of December 2017

Within private equity, there tends to be a lot of variation both by vintage year and between top-performing managers and laggards.

Source: Cambridge Associates, PE & VC Benchmark Statistics as of December 2017

* IRR: Internal rate of return is a common way to estimate the profitability of an investment, by comparing the discounted value of future cash flows to initial investment costs. The IRR is calculated by looking for the discount rate at which these amounts cancel each other.