Style drift concerns may not affect private equity allocations

NEW YORK — Private equity investors are worried about style drift and declining returns but more than a third still expect to increase their allocations, according to the Global Private Equity Barometer, a semiannual survey of private equity limited partners by Coller Capital Ltd.

The survey reported that 49% of institutional investors plan to increase their allocations to alternative investments in the coming year, with 38% planning to increase their allocations to private equity and 40% expecting to increase their hedge fund allocations. Two percent of alternative investment investors, 3% of private equity investors and 10% of hedge fund investors plan to decrease their allocations and the rest would keep their allocations the same.

Eighty percent of survey respondents expect a significant number of new investors to invest in private equity over the next three years. Some 68% stated they thought new investors would be motivated to invest in private equity by higher returns; 32% thought diversification would be their prime motivator.

Returns over the lifetimes of portfolios held by private equity investors have been fairly consistent, said Frank Morgan, president and chief operation officer of Coller Capital-U.S., New York. However, lifetime portfolio returns this year dropped. Only 41% of investors reported net returns over the lifetime of their private equity portfolios of 16% or greater; last year, nearly 45% reported returns at that level.

Within their private equity portfolios, 58% of all investors stated that the European buyouts portion of their portfolios returned 16% or more; 45% of North American buyouts returned 16% plus; 33%, funds of funds and generalist funds; 24%, North America venture capital; and 11%, European venture capital.

The majority of investors, 74%, stated that style drift by their private equity fund investment managers into new strategies or new locations than originally stated when their funds were raised would impair future returns. This is the first time this question was asked, and Coller executives attributed the predominance of this view to the lagging economy and the credit crisis, Mr. Morgan said.

“We were getting a whiff of this in the marketplace,” he said.

A number of Coller's general partners had asked for permission to add new strategies or new locations to the mandates of existing funds, he said.

“I was surprised how pervasive (this is) and how concerned investors are,” he said. “I think it has to do with nervousness with the economy in general and the credit crisis' impact on the availability of credit for transactions.”

Investors in North America are the most concerned, with close to 90% saying they believe style drift would negatively affect private equity returns. At the same time, investors expect the pace of investment by their managers to slow but not stop. Forty-two percent of investors expect less of their capital to be called by private equity fund managers in the next 12 months, up from who reported the same thing in last year's survey. Some 42% expect the same amount of capital will be called and 16% more money to be called than last year.

Investors see a few bright spots on the private equity investment horizon in the next 12 months. Survey respondents indicated that European buyouts would offer the most attractive opportunities for private equity firm investment in the coming year, followed by Asia-Pacific buyouts and North American venture capital. When asked to select the top performers by deal size, investors indicated that lower midmarket buyouts of less than $200 million would be the best types of private equity investments for general partners. Midmarket buyouts of between $200 million and $1 billion ranked second, and growth expansion capital investment was third. Health care and biotechnology is the top sector for investment over the next 12 months, with financials services and technology in the second and third spots.

Distressed debt is a hot area for investment. Two-thirds — about 65% — of North American limited partners already invest in distressed debt, while 35% of European investors and more than 40% of Asia-Pacific limited partners already invest in distressed debt. Even so, 28% of Asia-Pacific investors and 18% of European limited partners expect to begin investing in distressed debt within the next 12 months. Less than 10% of North American limited partners plan to begin investing in distressed debt. This interest in distressed debt appears to be linked to investors' return expectations. Twenty-five percent of investors expect returns of 11% to 15% in the next three to five years, while slightly more than 30% expect 16% to 20% returns; 15% anticipate returns of 21% to 25% over the same period.

IE Consulting, London, conducted the survey of 103 private equity fund investors on behalf of Coller in February through April.

Contact Arleen Jacobius at [email protected]