Getting back on course

Transcription

1 Getting back on course The first annual survey of investors in private equity 2010 Investors press their advantage Poor returns may hasten consolidation RESEARCH Sponsored by: Regulatory spectre obscures outlook Demands for greater transparency

2 2 «Limited Partner Survey 2010 Investors return, but with new agendas The first annual survey of investors in private equity 2010 Last year, private equity experienced perhaps the biggest storm of its short life. Firms and investors everywhere faced unprecedented lack of visibility, as debt markets locked and equity markets boomeranged. Starved of funds for new deals, and with huge uncertainty hanging over economic growth, firms battened down the hatches and focused on portfolio companies, triggering an 80% year-on-year drop in European deal volumes, according to data provider Dealogic. In response, limited partners (LPs the investors in private equity funds) slowed their commitments to the industry to a trickle. But as the storm abates, investors do not appear to have lost their enthusiasm for the asset class, judging by the results of Private Equity News s inaugural LP survey. Despite the trauma of last year, more than half of LPs plan to increase commitments this year just 10% plan to pull back. That does not mean a return to the boom years for private equity firms, however. Sensing that the pendulum of power has swung their way, LPs are adamant that this time they will invest on their terms. That means a determined push for lower fees and greater transparency, as well as a tilt away from mega-buyouts and towards the midmarket and growth capital. LPs are also seeking more efficient ways to invest, through direct purchases of companies and co-investments alongside private equity managers. Jeremy Coller, founder of secondaries specialist Coller Capital, said: Investors have always wanted lower fees, more transparency, and opportunities for co-investment, but they are more likely to get them in the current environment. The balance of power, which favoured general partners [GPs private equity firms] too strongly in the boom years, has swung back towards LPs. Contents Introduction Keen, but picky Investors press their advantage Poor returns may hasten consolidation Regulatory spectre obscures outlook Show me the money Inevitably, this new assertiveness will create losers. Those funds that have underperformed will find themselves unable to raise new funds. More than 80% of respondents to our poll said they would invest with new firms to help boost returns. Three-quarters expected a subsequent consolidation among general partners. Meanwhile, the outlook is far from clear. As discussions drag on around new European regulations, two-thirds of investors were not clear how mooted changes would affect them. And as Britain prepared last week to go to the polls, more than 80% of investors were unsure about how new taxes would affect their strategies. Thanks to responses from 80 of the biggest investors in private equity, this poll explores LPs attitudes to the asset class. Financial News Stapleton House, Scrutton Street, London EC2A 4HU, UK. Tel: +44 (0) Fax: +44 (0) (editorial) Fax: +44 (0) (advertising) letters@efinancialnews.com website: Published by efinancialnews Ltd 2010 Registered as a newspaper by Royal Mail. All rights reserved. No part of this publication may be reproduced or used in any form of advertising without prior permission in writing from the editor. ISSN Editorial Editor Report author Production editor Production manager Printed by James Mawson Tom Fairless Keith Baldock Greg Russell Pureprint Subscription order enquiries Contact Dominic Legg Tel: +44 (0) dominic.legg@dowjones.com

3 Advertorial The Private Equity World of 2010: Can greater transparency and better governance mitigate volatility and improve performance? Over the past two years, the global economy has suffered through severe economic distress. While there are indications that the worst may be over, we are not back to the frothy times of 2006 and early As shown in the recently released PE News/Duff & Phelps survey, investors expect to substantially increase the pace of their commitment to private equity during 2010 compared to Such expectations demonstrate optimism from investors as they make their investment decisions. Yet, we are far from the days when Fund Managers could dictate terms, limit allocations, and tell their LP s to sit in the corner and watch. In many ways the investment environment, while better, remains cloudy and unclear. Visibility into the future is never clear. Today, many Fund Managers are expecting a return to historical investment results. However, the future can unexpectedly become murky, just like the air over Europe after Iceland s recent Eyjafjallajokull volcano eruption. Some have argued that the concept of Fair Value has somehow added to volatility and impacted economic results. Others maintain that transparency and governance are of prime importance, now more than ever. During 2010 both the US Financial Accounting Standards Board and the International Accounting Standards Board will release new rules on measuring and disclosing fair value. In late 2009,the Institutional Limited Partners Association (representing the LP community) issued guiding principles for private equity investments. The goal of the principles is to restore and strengthen the basic alignment of interests in the private equity industry as well as strengthen the asset class as an institutional investment strategy. The principles outline best practices in private equity partnerships; ie: the alignment of interests, governance and transparency. So how does one reconcile the increased need for strong performance or outsized returns, from private equity investments, with the desire to reduce volatility and a regulatory environment which demands greater transparency accompanied with stronger governance? First and foremost, it must be recognized that the amount of capital deployed by private equity, the increased number of investors, and the accompanying populist sentiment fueled by the recent economic downturn, have moved private equity investing into a more institutional and visible position. For good or bad, Private equity has become institutionalized and must continue to demonstrate appropriate governance and transparency. The Private Equity Industry, through the issuance of the International Private Equity and Venture Capital (IPEV) Valuation Guidelines, has demonstrated the ability and desire to provide best practice for alternative investment investors. There are some managers and investors who still hold to the old belief, that cost is a better approach to reporting private equity investments. They miss the point that volatility exists whether or not it is measured. Even with its failings, a Fair Value reporting system is the best option because: Fair Value is the best basis to make apples to apples asset allocation decisions. Fair Value allows interim investment (manager selection) decisions on a comparable basis. Fair Value is often necessary as a basis to make incentive compensation decisions at the investor level. Fair Value provides a comparable basis for monitoring interim performance in the context of exercising the investor s fiduciary duty. Most investors are required by relevant GAAP to report their investments on a Fair Value basis. Therefore, most LP s require Fair Value. Investment Companies (under US GAAP, and proposed IFRS standards) are exempt from consolidation rules because their investments are carried at Fair Value. Limited Partners need consistent, transparent information to exercise their fiduciary duty. Fair Value provides such information. An arbitrary reporting basis such as cost does not allow comparability. The PE News LP Survey results demonstrate that Investors who are maintaining or increasing their commitment to Private Equity are expanding their internal procedures and are requiring more robust disclosures from their managers. Best practice is evolving to use a qualified, experienced third party to validate Fund Management s assessment of fair value to reduce the independent work required by Investors. While Private Equity did not cause the recent economic crisis, there continues to be pressure from some politicians for greater regulation of the alternative asset industry. Appropriate new regulation, matched with existing self regulation, such as that provided by IPEV, should provide a framework for by LPS and GPS to invest successfully in the years to come. For more information, please contact David Larsen, Managing Director at or visit duffandphelps1.com/fairvalue for more information.

4 4 «Limited Partner Survey 2010 Keen, but picky Last year, the prospects for fundraising looked bleak. As returns plunged and investors fought fires in their portfolios, the amount of cash raised by private equity firms globally slumped by more than 60% to $245.6bn, the lowest in five years according to data provider Preqin. The market peak in 2007, when firms raised $646.2bn, seemed far away. Today, though, investors are back. According to our survey, more than a fifth of respondents planned to lift the pace of commitments to private equity this year by 25% or more, with a further third set to boost commitments by up to 24%. Just 10% of respondents said they would reduce investment. Ross Marshall, chief executive of UK midmarket firm Dunedin, said: Very few funds raised money last year, so LPs need to deploy money to private equity this year to fall in line with their asset allocation strategies. Everyone clearly wants to put money to work. Part of the reason for the resurgence is that appetite is rebounding from a very low base, according to Jeremy Coller, founder of secondaries specialist Coller Capital. He said investors also remained convinced of the benefits of private equity. He said: More broadly, LP appetite has Asset class remains in favour, but LPs are more fussy about how and where they invest held up because even if a few investors have been discouraged by changed circumstances or unrealistic expectations, most still think private equity has a good risk-return profile relative to, and in combination with, other asset classes. Mark Wignall, chief executive of Matrix Private Equity Partners, added: The industry s detractors allege that GPs lost money because they paid too much, took on too much leverage and overcommitted. But that does not seem to be the majority view here. Many investors seem to think this is a good time to invest based on the opportunities going forward and low entry values. The renewed investor appetite may even represent a vindication of the private equity model, according to some executives. Marshall said: Many businesses have come through strongly because their private equity backers were in a position to inject extra capital. Some of those would have failed without private equity backing. But despite investor confidence, not all firms will find it easy to raise new funds. Specifically, firms that focus on buyouts worth more than 1bn may struggle just 11% of respondents said they planned to increase investment in the sector. Marshall said: Large buyouts rely on debt and syndicated debt, but those markets are still moribund. Potential new regulations in the US and Europe would put capital constraints on banks, which would serve as a further barrier to large leveraged deals. But the mid-market is open for business because it is less dependent on debt. Public-to-private deals and private investments in public equities have also fallen from grace following the sharp rebound in equity prices since March last year. Marshall said: Firms cannot afford the multiples on public companies without debt, which remain constrained. Instead, investors are focusing on midmarket buyouts and growth capital, with more than 60% of respondents keen to boost investment in those sectors. Jos van Gisbergen, senior fund manager at Netherlands-based investor Mn Services, said: There is a trend towards greater investment in growth capital and mid- Do you expect to change your commitment to private equity funds in 2010 versus 2009? Decrease substantially (25% to 49%) 2.5% Decrease slightly (0-24%) 5.1% Decrease dramatically (50% or more) 2.5% Increase slightly (0-24%) 32.9% Keep the same 35.4% Increase dramatically (50% or more) 8.9% Increase substantially (25% to 49%) 12.7%

5 Limited Partner Survey 2010» 5 In which sectors do you plan to increase investment? % market buyouts because both offer interesting returns and fairly low risk Coller said: Growing and restructuring European companies will provide many opportunities for private equity over the next few years, hence investors interest in mid-market buyouts and growth capital. 0 Venture capital Growth Capital Private investments in public equities Publicto-privates Mid-market buyouts Large buyouts (+ 1bn) Venture capital looks set for a more modest rebound, with more than a quarter of LPs keen to increase commitments. That resilience is somewhat surprising given the European venture industry s poor returns. According to the European Private Equity and Venture Capital Association, Europe s venture capital firms have produced average internal rates of return a measure of annual profitability of just 0.7% a year over five years, and 1.9% a year over 10 years. Returns in the US are much higher firms return 4.9% over five years and 8.4% over 10 years, according to the US National Venture Capital Association. Van Gisbergen said: It is surprising that more than a quarter of investors plan to increase investment in venture capital because 10-year data for the sector is a really big disaster. Moreover, investors can only deploy small amounts in VC because the European market is small, but funds are increasingly large. That makes investment problematic. to be deployed, so funds have a great deal of buying power. There are likely to be some good large buyouts this year. Last month, Private Equity News reported that a group of large banks was understood to be putting together a $10bn loan to finance the buyout of a US public company. If the deal went through, it would be the largest private equity buyout since the credit crisis in mid China and Latin America were among the most favoured regions for investment, with North America and continental Europe also drawing strong support. Van Gisbergen said: North America is a very interesting market. China and Latin America are still in favour, although Brazil is the only interesting market in Latin America, and there is a big overhang of money there. If everyone goes the same way, good opportunities evaporate. LPs showed less interest in the UK and Ireland, central and eastern Europe and the Middle East, all of which enjoyed strong investment during the boom years. Marshall said: Many LPs are deciding where to invest based on the relative economic strength of different regions. The US is recovering strongly, but some European countries are still struggling. The UK looks set for a relatively slow recovery, but that means prices are relatively interesting. In which countries/regions do you expect to increase or decrease investment in 2010? But according to Coller, the travails of European VC mean surviving firms are very good indeed. He said: Investors are keen to invest with top firms, although there is still generally a more positive attitude towards the US venture industry than its European counterpart. One thing is certain: there is a clear need for venture capital investment in Europe. Meanwhile, some investors regard the lack of confidence in large buyouts as an opportunity. Van Gisbergen said: Large buyouts are still out of favour, and that makes it an interesting sector to look at. The banks are starting to provide leverage again and underwriting deals. There is also a big overhang of money raised that has yet North America UK and Ireland Continental Europe CEE, Russia and CIS Middle East India Japan China Southeast Asia Latin America Africa 0 Increase Decrease %

6 6 «Limited Partner Survey 2010 Investors press their advantage Investors have moaned about private equity fees for years. Gripes have typically focused on management and transaction fees, both of which contradict the claim that firms are paid according to performance. As the pendulum swings their way, LPs can finally demand better terms As fund sizes exploded, the practice of charging 2% of a fund s total value in annual management fees enabled top firms to grow rich before any performance hurdles were met. Even so, investors played along when times were good, keen to enter sought-after funds. Today, the boot is on the other foot. With fund values far below their peaks, a huge overhang of capital from the boom years and many firms desperate for new funds, investors are in a strong position to demand change. Wignall said: Greater savviness from LPs is the vein that runs through this survey. Investors are pushing for greater control over their investments, more transparency and lower fees. While they may be willing to invest more in private equity, they want to make some adjustments. According to our survey, four-fifths of investors expect management fees to fall this year. Almost a third expect performance fees to come down too. Meanwhile, more than half of respondents expected key-man clauses which enable investors to alter contractual terms if a key employee leaves to become more rigorous. Van Gisbergen said: Everyone thinks terms and conditions have shifted towards LPs. That change may not be happening fast enough, but it is happening. And indeed, evidence has emerged in recent weeks that LPs are getting their way. US buyout firm Apollo Management said last month it would trim the fees it charges the California Public Employees Retirement System, the biggest US pension fund, by $125m over the next five years. Other firms, including First Reserve, are said to be renegotiating terms with Calpers, while TPG and Carlyle Group have recently made concessions, according to reports. But firms will face differing levels of pressure to cut fees, according to Marshall. He said: Mega-funds in particular are under pressure to reduce fees because their earnings from fees have been so high. But top firms will still be able to charge more if they have outperformed. In what ways do you expect to change your investment style? Yes, management fees to fall Yes, management fees to rise Yes, performance fees to fall Yes, performance fees to rise Yes, key man clauses to be more rigorous Yes, other changes No %

7 Limited Partner Survey 2010» 7 In what ways do you expect to change your investment style? An executive at one of Europe s biggest private equity firms said: The pendulum is swinging back in investors favour on fees. But in practice, the outcome will be quite varied. Investors are likely to take what they are given if offered the chance to invest with a top-performing firm. But even top brand names have agreed to split transaction fees with investors. And if investors see any weakness, such as a mixed track record or a new fund, they will push for better terms. Stop doing direct deals 5.1% Increase direct dealmaking 10.3% Start doing direct deals 7.7% Decrease co-investments 5.1% Start a co-investment program 30.8% Increase co-investments 41.0% Meanwhile, nearly a fifth of LPs plan to start or increase direct deal-making, which involves bypassing private equity firms and buying stakes in companies directly. Marshall said: We are starting to see changes in the way LPs invest, with some investing directly in large companies. That is just part of the evolution of the relationship between LPs and GPs. Most GPs started as captive units of banks in the 1980s, but 99% now operate independently. Several large Canadian pension funds have pushed into direct investment in recent weeks. Last month, the Ontario Teachers Pension Plan won the auction to acquire Camelot Group, the UK national lottery operator, for about 389m ( 431m), beating buyout firm CVC Capital Partners. Meanwhile, the Alberta Investment Management Corporation, another Canadian pension fund, expressed an interest in acquiring listed UK buyout house Candover Investments, according to a source. But according to Coller, many investors will not be capable of executing direct deals, which require a different set of skills. He said: Most investors would like to co-invest, to access attractive investments at lower cost. Direct investment, on the other hand, is another ball-game entirely. Some large and experienced investors have taken that route some of the big Canadian pension funds, for example, and a number of sovereign wealth funds are also interested but getting the model right is very difficult. Direct investment requires different skills from being an LP, and the transition is not easy. LPs new-found power has also encouraged them to invest in new ways. Nearly threequarters of respondents said they expected to increase co-investment or start a coinvestment programme this year. This strategy enables LPs to invest more in specific transactions, thereby boosting exposure to the best deals and locking in favourable terms. Wignall said: Many investors are happy with the 10-year limited partner structure, but also want to explore slightly different structures. Co-investment is clearly popular because it involves deploying capital in a slightly savvier way. If GPs have a really good idea, LPs want to be able to participate more. But whether it will become widespread is not yet clear. According to van Gisbergen, co-investment provides a way for investors to curb high fees. He said: Funds of funds seem already to be favouring co-investment, but there is still a long and bitter debate among other institutional investors. They are not yet coinvesting because there is no one to underwrite the deals. Everyone thinks terms and conditions have shifted towards LPs. That change may not be happening fast enough, but it is happening Jos van Gisbergen Mn Services

8 8 «Limited Partner Survey 2010 Poor returns may hasten consolidation After a year in which plunging asset values hammered returns from private equity, particularly for the most leveraged deals, investors are understandably re-examining their relationships with private equity firms. Investors will shun some existing relationships [Nearly two-thirds of respondents to our survey said the asset class had performed worse than expected, while half said it had performed worse than other asset classes. While investors who came late to the asset class or were exposed to venture capital or highly leveraged deals will have seen poor returns, other sectors performed better, according to van Gisbergen. Do you expect to see consolidation among general partners in the coming year? Yes 74.7% He said: Private equity recouped some of its losses last year, with high-yield credit performing particularly well. I am not surprised investors are disappointed by returns. The question is how they react. This survey indicates they will continue to invest but there will be a flight to quality. Some investors may have been disappointed because they had unrealistic expectations. Van Gisbergen said: The volatility of returns has been worse than expected. But many investors had unrealistic expectations. They expected returns of more than 20% annually as well as low volatility. But there is no such thing as a free lunch. Coller said: Many of today s private equity investors are relatively new to the asset class. For those that have not previously been with private equity through a whole economic cycle, the sudden reversals of the last couple of years have come as a nasty shock. Marshall added: Returns from a lot of big funds do not currently look good. But longterm LPs realise they need to wait until the cycle corrects itself and firms can exit investments before judging returns. But while some LPs may be content to take a long-term view, those that have been badly burned are likely to rethink their relationships with specific firms. According If yes, how will it happen? No 25.3% Through inability to raise new funds 88.1% Through mergers or combinations of firms 11.9%

9 Limited Partner Survey 2010» 9 Have private equity returns and volatility meant as an asset class it has performed better or worse than either your expectations or other asset classes? to our survey, fewer than a fifth of respondents plan to stick with existing relationships, with the remainder looking to invest with new firms. Coller said: If GPs have underperformed, or investors suspect their good returns came from little more than leveraging a rising market, they will struggle to attract commitments to new funds. The struggles of such firms may spark % Your expectations Better Worse Other asset classes consolidation of the industry. The Boston Consulting Group and IESE Business School predicted 18 months ago that between 20% and 40% of firms would disappear in the wake of the financial crisis. Since then, several firms have gone out of business, some have reduced their current fund commitments, and others have reduced their teams, including senior partners, according to Heinrich Liechtenstein of the IESE and Heino Meerkatt of BCG. Three-quarters of respondents to our poll said they expected consolidation among GPs in the coming year. Of those, nearly 90% thought that would arise from firms inability to raise new funds. Van Gisbergen said: There is unlikely to be much consolidation through GPs buying other GPs. But some firms are likely to disappear as they fail to raise new funds and staff leave. The next two years will be crucial. Some firms who asked us for money 18 months ago are coming back again now because they have still not hit their targets. Such firms will need to shrink or close their funds. According to Marshall, about 20% of firms might disappear in the next few years, although new firms are likely to spring up in their place. Wignall said: The industry s customer base senses that greater consolidation is likely, but that will probably not happen in the coming year. Over the next three years, though, we will start to see significant consolidation. Van Gisbergen said listed vehicles were in more trouble than the rest because many had overcommitted, while some midmarket firms that had failed to perform well during the crisis would not raise a new fund. Many of today s private equity investors are relatively new to the asset class. For those that have not previously been with private equity through a whole economic cycle, the sudden reversals of the last couple of years have come as a nasty shock. Jeremy Coller Coller Capital

10 10 «Limited Partner Survey 2010 Regulatory spectre obscures outlook A spectre is haunting Europe s private equity industry regulation. Investors still have no idea how new rules will affect them Desperate to prevent a repeat of the excesses that led to the financial crisis, European legislators are pushing through the Alternative Investment Fund Managers Directive that aims to tighten control of private equity firms and hedge funds. The legislation has been much criticised by the industry, with US politicians adding their voices because of plans to restrict foreign funds access to the European Union s institutional investors. The furore surrounding the directive and the slow pace of debate over multiple drafts have left most investors confused as to how the rules will affect them. According to our survey, two-thirds of respondents said they did not know whether regulatory changes would affect their investment in private equity. A quarter said changes would make commitment less likely. Investors were even less clear on possible alterations to the tax regime. More than four-fifths said they did not know whether changes would affect their strategies. Van Gisbergen said: Nobody has a clear view on how tax and regulation will affect the industry because the final outcome is still uncertain. But the AIFM Directive should be passed in the next few months, and that should clear matters up. Coller said: It is difficult for anyone investors included to guess exactly what impact new taxes and regulatory initiatives will have on the industry in the next few years. In the UK, for instance, it is not yet clear what the tax environment will look like even next month. In general, limited partners are concerned that the impact of new regulations will not be wholly beneficial. The first draft of the AIFM directive, for example, would have been very damaging to the industry. If regulatory changes constrain the private equity model, returns may look less Will potential tax changes to private equity make you more or less likely to invest in the industry? More likely 6.8% Less likely 27.4% Don t know 65.8% attractive and this could result in a shift away from private equity, according to Marshall. More likely 4.1% Less likely 13.7% Don t know 82.2% Will potential regulatory changes to private equity make you more or less likely to invest in the industry? He said: That is a real danger if the directive goes ahead in its current form.

11 Limited Partner Survey 2010» 11 Show me the money As investors grow accustomed to their newfound power, their focus has gone beyond fees to transparency and governance. Last September, the Institutional Limited Partners Association a trade body that represents some of the biggest investors in private equity unveiled guidelines aimed at increasing its members influence over fund terms. These guidelines sought to align interests between investors and buyout firms, to improve investment reporting and transparency, and to enhance governance. Two-thirds of the investors that responded to our survey said they supported the Ilpa principles. A similar proportion described them as influential in shaping terms and conditions. However, more than a quarter of respondents said they were not familiar with the principles. Meanwhile, nearly 60% of respondents said GPs had increased the rigour of their estimates of the value of portfolio companies last year, and more than half said they would shun a top-performing fund that did not regularly provide good fair-value estimates. Almost a third of investors said they had adopted new guidance, published in September by the International Private Equity and Venture Capital Valuation Board, to determine the fair value of a limited partnership interest in a private equity fund. Van Gisbergen said: GPs estimates of fair value are getting better and better because they are under more pressure to put in place a good process. But there is still too much room in the definition of fair value. Some groups are very conservative in their estimates, while others are very responsive to market conditions. But he added it was worrying how many investors were not familiar with the Ilpa and Ipev guidelines. He said: The survey shows that a quarter of investors have not heard of the Ilpa guidelines and more than a third have no clue about the Ipev guidelines. That means they cannot value underlying assets, and therefore do not know whether they have made good investments. It is worrying that there are still so many unsophisticated investors. Transparency is key in the wake of the crisis During 2009, what is your assessment of the consistency and rigour of your general partners estimate of fair value of underlying portfolio companies? It depends 40.5% That is mainly the fault of LPs themselves, although GPs and trade bodies are clearly not doing enough either. Yes 8.9% No 50.6% However, the high proportion of LPs that are ignorant of the guidelines may simply illustrate the diversity of the LP community, according to Coller. He said: It is easy to think of LPs as a homogeneous group, but in fact they encompass a very wide spectrum of organisations from small Decreased 5.2% Stayed the same 35.1% GP doesn t report Fair Value 1.3% Increased 58.4% Would you invest in a top-performing fund that does not provide transparent, robustly determined, fair value estimates on a regular basis? family offices to giant pension funds and sovereign wealth funds. While all the large institutional investors are aware of the Ilpa and Ipev guidelines, some smaller private equity investors are not. Marshall added: Investors that only started to invest in private equity in the run-up to the bubble are understandably less knowledgeable about the guidelines. But of those that are familiar with Ilpa, two-thirds support the guidelines.

12