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Industry Voices

Commentary: What investors should look for in the changing PE market

The heat wave that gripped much of the Northern Hemisphere over the summer months provides an apt metaphor for the current state of the global private equity and real estate industry.

Just as Europe and North America sweltered under record temperatures and aridity, "very hot and exceedingly dry" more or less summarizes the state of the alternative investment market. And just like this climate eventually gave way to storms and rains, the industry is likely heading into a more difficult, more turbulent period.

Despite a slight ebb in the second quarter, firms are raising money at a pace and level not seen since before the financial crash. According to Preqin, 2017 saw a massive 20% increase in funds under management, the highest rate of annual growth ever recorded by the firm, bringing the industry's total assets under management to more than $3 trillion. The average fundraising period has now fallen to 12 months, half of what it was in 2010.

This is all quite understandable considering that the industry has frequently posted double-digit returns in a post-crash era marked by a paucity of yield. However, it has led to a situation where the flow of money is fairly one way. The amount of dry powder has increased in lockstep with AUM growth, rising 24% in 2017 to a record level of $1.1 trillion — with some estimates putting the figure as high as $1.5 trillion. The trend has become self-perpetuating. Fund managers have more and more capital with fewer and fewer attractive options for spending it, which only pushes deal values higher, continuing the cycle.

As such, and despite the overall buoyancy of the sector, the market may be about to enter into a tricky phase, which will take skill to navigate, both from the perspective of firms and investors. Paper gains are all very well and good, but ultimately don't mean anything until they convert to actual gains via exits. The risk now is that the fierce competition for investment opportunities will inflate deal valuations to the point of seriously impacting returns. And while this might be a short-term phase to allow for market rebalancing, investors who are used to outperformance from the sector — or have recently moved into the sector, drawn by the allure of double-digit returns — may find such a dip difficult to stomach.

Simply allocating assets to a few funds with good prior performance, sitting back and waiting for the profits to roll in is fine when returns are flowing. But should there be a period of tightening, investors will need to take a more proactive, forensic approach to ensure bang for buck. While gold-standard communications may have been a more peripheral concern in the past, periods like this are precisely those in which it comes to the fore. Investors would do well to prioritize managers that are able to regularly and efficiently provide comprehensive information on portfolios, explaining the situation and their strategy for navigating it.

Of course this has been on limited partners' radar for some time; investors have been agitating for greater transparency into their investments for a number of years. But while the industry has undertaken some good collaborative work in response to this issue — for example, the establishing of common data standards — there is still a long way to go, and the crunch point may be about to arrive.

One problem is that while standardization is admirable, it doesn't help provide the sort of granular, customizable information that LPs so often need. Investor needs and remits are incredibly diverse, and in the digital age there is little excuse for any sort of one-size-fits-all approach.

Too many firms, however, continue to fail to meet even this standard. Despite a recent wave of investment in technology, some parts of the industry remain relatively low-tech relative to their peers in finance, with much of this visible in the area of investor communications. A recent survey of Augentius investors around the globe revealed that only half of managers are providing investors with enough information on a routine basis without investors having to make additional requests. Even more concerning, 1 in 5 investors reported never receiving additional information requested. Far too many funds still rely on utterly outmoded, simplistic and ad-hoc forms of communication such as email and PDFs.

From the investor point of view, all of this lack of effective communication adds up to more work, less foresight and lower returns. While these concerns may have been a tolerable annoyance for some in the past, it could mean the difference between a worthwhile and mistaken investment in the more difficult waters ahead.

The barriers here are cultural rather than financial or technical. Well-tested and relatively low-cost platforms now exist that can automate much of the reporting process, allowing investors to access far more in-depth, frequently updated and granular information tailored to their specific needs without any corresponding increase in cost or effort. (In fact, there are often net savings given the efficiency gains.)

If this sort of gold standard wasn't a priority for investors before, it should be now. The industry will only truly modernize once investors start voting with their assets. And in the coming storm it could mean the difference between success or failure.

Ian Kelly is CEO of Augentius, London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.