Troubled but optimistic

First, the good news. In spite of everything – credit crunch, banking collapse, economic downturn et al – private equity investors have retained their apparently unshakeable belief that the asset class remains a great bet in the long run. What else would explain their strong appetite to access funds, which continues regardless of trifling matters such as a near collapse of the global financial system?

In the Winter 2008/09 version of secondaries firm Coller Capital's Global Private Equity Barometer, investors' faith in private equity is clear, with 97 percent of those canvassed saying they plan to maintain or increase their target allocation to private equity over the next year. This level of commitment, says the report's authors, is broadly in line with that expressed in recent years.

However, while there is no problem with lack of enthusiasm, there is a big practical problem as limited partners run up against their maximum target private equity allocations. The so-called “denominator effect” is real, and can be seen in the chart below from the same report. It shows that, by the end of this year, two-thirds of LPs will be at or above their target allocations. The problem is particularly acute in North America, where 28 percent will have exceeded their targets, compared with 19 percent in Asia Pacific and 14 percent in Europe.

A second survey, produced by placement agent Acanthus Advisers, reveals another potential problem for GPs on the fundraising trail. Namely, they have used up much of their investors' goodwill. In the same survey a year ago, Acanthus says “the key theme was that GPs were tending to overestimate the quality of their communications and used their bargaining power to demand generous terms, much to the discontent of their investors”.

This discontent is reflected in the latest findings (see chart p. 59 top left), with 75 percent of LPs saying relations with GPs could be significantly improved, compared with 68 percent a year earlier. Nearly two-thirds of GPs agreed with this assessment. However, 58 percent of LPs and 69 percent of GPs said that the investor relations process had become more effective.

Perhaps the biggest bone of contention between GPs and LPs relates to the terms and conditions of funds. Nor is it surprising that LPs should now be expressing dissatisfaction with a legacy of lucrative fees and generous carry arguably more suited to the boom of prior years than the downturn of today.

The Acanthus survey reveals how divisive terms and conditions are, with LPs seeing much room for improvement and GPs largely oblivious to their concerns (see chart above right). For example, whilst almost all LPs in the survey felt that fund managers should invest more in their own funds, only around half of GPs agreed.

A third survey of LP attitudes from US placement agent Probitas Partners highlights the reluctance of investors in a volatile climate to form new GP relationships (see chart below left).More than 11 percent of LPs in the Probitas survey said that either their 2009 allocation was completely used up or that 90-100 percent of the allocation would be targeted at re-ups with existing managers. This compares with 3.7 percent in the equivalent survey a year prior.

For those funds that can be raised in spite of capital restrictions, the future looks bright indeed. It is striking that, in 2008, Probitas found the most popular view to be that top-quartile buyout returns would be less than for the previous year. By sharp contrast, nearly twothirds of LPs believe that 2009 returns would be better than 2008 (see chart below). No wonder appetite remains so strong – in spite of all those apparently countervailing forces.