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Outlook 2017

Uncertainty weighs on private equity forecast

Susan Long McAndrews said global political shocks have upended many once-solid scenarios.

Lack of consensus on future could hit already soft activity

The forecast for the private equity asset class in 2017 is cloudy with a high probability of uncertainty, and that could slow fundraising, industry executives say.

Fundraising already has moderated. Private equity funds amassed the lowest amount of capital in the third quarter of 2016 since the third quarter of 2013, with 170 funds closing on a combined $62 billion as of Sept. 30, according to London-based alternative investment research firm Preqin. Third-quarter total capital raised was down from $110.6 billion raised by 241 funds in the second quarter and $73.4 billion raised by 180 funds in the third quarter of 2015, Preqin data shows.

But industry insiders pretty much disagree on everything else and, most especially, what this uncertainty will mean for private equity next year. Some managers are predicting an extension of the credit cycle that, until the elections in Europe and the U.S., was on the wane. That would lead to an increase in transactions. Other industry executives predict deal activity could slow as a result of political and economic uncertainty.

Private equity executives also disagree on whether it is possible to choose winning and losing sectors within the industry. Among the executives who would take a stab at it, health care and energy were on some managers' lists of potential investment opportunities while others cited those same sectors as having the most potential for investment disaster.

“My crystal ball like all crystal balls will probably be wrong,” said Russell Steenberg, managing director and global head of the private equity partners group within BlackRock (BLK) Alternative Investors, New York. “In the U.S. and Europe there's a strong populist nationalist trend, which is having a huge impact on creating uncertainty.”

This uncertainty makes it difficult to discern the threats that lie in wait for investors in 2017 and beyond, Mr. Steenberg said.

Borrowing a theme from her firm's annual investment outlook report, Susan Long McAndrews, partner in the San Francisco office of alternative investment firm Pantheon Ventures, said there are scary monsters out in the world. But investors need to continue investing because top-performing vintage years are best selected in hindsight.

“The best inoculation against any environmental issue is steady investment year in and year out, because you can't predict cycles,” Ms. Long McAndrews said.

The anti-establishment voting around the world has led to unpredictable outcomes, she noted; sector themes that were solid within the past 18 months have been “turned on their heads.”

Before the elections in the U.K., the U.S. and Italy, things were different. Then, everyone agreed many economies were at the tail end of their recoveries and so private equity investors needed to pay more attention to manager selection than macroeconomic factors, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc., a subsidiary of Willis Towers Watson PLC.

Since the change in political tone, investors will have to spend more time and be a lot more judicious with their private equity investments, he said.

Even with a great manager, investors need to ask: “Do I think the impact of the macro (economic factors) will overwhelm the skills of the manager,” Mr. Mansukhani said. “Investors will probably take more time and, by extension, it should slow down fundraising.”

The larger firms will continue to have no problem raising funds, said Anthony D. Tutrone, New York-based managing director, global head of the alternatives business at Neuberger Berman. “We've seen a very friendly market for fundraising, in my opinion. After the financial crisis we didn't expect it to happen again where the very, very large funds were massively oversubscribed.” he said.

However, some smaller firms without stunning performance have struggled to raise money, he said.

This “consolidation of power” and assets in the largest private equity firms will continue as investors reduce the number of private equity manager relationships, he said.

BlackRock's Mr. Steenberg also foresees a continuation of the concentration of private equity assets with fewer firms.

“On the fundraising front, the (general partners) which have great performance and great brand name will raise money in a faster fashion. Firms with great brand names with just OK performance, you will raise money but won't be oversubscribed,” Mr. Steenberg said; and those firms “that should have fallen off the pumpkin truck will not raise money.”

However, the flood of distributions that has outpaced commitments over the past three to four years will begin to taper off next year as private equity firms achieve fewer exits, he said.

Still, asset owners will continue making commitments to private equity because of the expected low return of stocks and bonds, he said: “Investors are looking for return, perhaps not paying as much attention to risk as they should and, as a result, everyone is moving into the illiquid markets.”

Kevin Campbell, managing director-private markets at DuPont Capital Management Corp. in Wilmington, Del., also foresees fewer distributions. The flood of distributions had pushed investors' portfolios below their private equity targets, and a slowdown in distributions could give some investors a welcome breather, he said.

“It will give investors' portfolios a chance to move up” to their target allocations, Mr. Campbell said.

The impact on returns depends on the duration of the slowdown, he added.

“If it's for a year , it won't be a big deal. If it's for three years,” slower distributions could cut into investor returns, he said.

Push out the credit cycle

Theodore Koenig, president and CEO of Chicago-based middle-market private debt manager Monroe Capital LLC, expects the corporate tax cuts and spending programs promised by President-elect Donald Trump will push out the credit cycle over the next two or three years.

This will result in a lot of deals in 2017, he said.

“It will be good for the private equity business and will be great for the private debt business,” Mr. Koenig said.

Energy also will benefit because new pipelines will get built in the U.S., he said. However, there will be a reduction in federal climate change funding initiatives, with a relaxation in air and water regulations and coal industry regulation, which will make alternative energy less attractive.

“Oil and gas will stay, and wind, solar and electricity will be more challenged because none will be able to stand alone on a free-market basis without government subsidies,” Mr. Koenig said.

Andrew McCaffery, Aberdeen Asset Management PLC's London-based global head of alternatives also believes the new U.S. administration could be good for energy investment, among other sectors.

“If (President-elect) Trump's policies play out it could be good for energy, parts of commodities, agriculture and infrastructure, as well as good for entrepreneurism,” Mr. McCaffery said. “The caveat is cycles will be quicker.”

BlackRock (BLK)'s Mr. Steenberg said that health care in the U.S. and around the world could offer investment opportunities.

“As economic wealth increases, people want to eat better and have better health care,” he said.

He also likes the energy sector, favoring not only fossil fuels but also, unlike Mr. Koenig, renewables.

Pantheon's Ms. Long McAndrews said it is unclear what will happen to the Affordable Care Act in the U.S. While firms that invest in companies that lower the cost of health-care delivery will continue to be good bets, the rest of the sector is uncertain, she said.

This article originally appeared in the December 26, 2016 print issue as, "Fundraising environment obscured by uncertainty".