Limited partner concerns

Establishing the true nature of LP investment intentions is a difficult task in the current market. Coller Capital’s recent private equity Barometer suggested that a majority of LPs were concerned that as GPs are finding it more difficult to allocate money to sectors and geographies where they possess most experience they will turn to areas where they have less experience. Alongside this so-called ‘style-drift,’ LPs are also concerned that fewer investment opportunities will mean cash outflows significantly exceeding inflows. It would be natural to assume that these two concerns might prompt a period of reflection by LPs or a re-shaping of the portfolio away from private equity. Not so, according to the survey. Nearly 40 percent of respondents plan to increase their allocation to private equity with only a tiny minority planning to decrease their allocation. However, Jeremy Coller, founder and CIO of Coller Capital, believes the seemingly contradictory responses actually reflect a ‘rational attitude. The growing appetite for private equity and alternative assets more generally is a structural shift. There is an increasing recognition among investors, especially pension funds, that private equity’s risk-adjusted returns are likely to exceed public market returns for the foreseeable future.’

Coller also says that, while they are unlikely to reduce exposure to private equity, investors will take a closer look at their portfolios. ‘What you’ll see increasingly is investors re-shaping their portfolios to focus on their best-performing GPs. They may also adjust the shape of their portfolios to reflect new economic realities. By way of example, this might mean less US buyout exposure and a greater focus on emerging markets.’ While LPs are cautious about the future, they have decided that private equity is the asset class perhaps best-placed to withstand the economic downturn and continue to out-perform most other asset classes.

On the question of ‘strategy-drift,’ 74 percent of LPs perceive this to be a threat to returns. Jeremy Coller believes the legacy of the technology crash is one factor behind these concerns. ‘Many private equity investors were investing at the time of the tech bubble and some got their fingers burnt as GPs threw themselves into areas where they hadn’t played before. LPs start worrying when they think GPs are being tempted to go too far off-piste,’ he says. The survey also revealed that LPs have rapidly adjusted to the new climate, with 42% expecting less of their cash to be called in the next 12 months, as opposed to the 7% who thought the same thing this time last year. The slowdown in investment pace is likely to mean that some GPs will be looking elsewhere for employment in the next year or so, believes Coller. ‘At the edges some GPs will not be able to raise a new fund.’

UK pension funds are one investor group which has had low exposure to private equity historically, with conservative trustees reluctant to sacrifice liquidity for higher returns. However there are signs that the mentality is now shifting. The £1bn Somerset County Council pension fund recently announced a £30m tender for a fund-of-funds manager and the UK’s second largest pension fund, the Universities Superannuation Scheme, has announced a $750m commitment to Boston-based Constitution Capital Partners with the intention of increasing its alternative exposure from 5 to 20 percent. Although both are encouraging signs, Somerset’s £30m allocation represents only 3% of its total portfolio and the USS cash is going to the US. The wisdom of investing such a large chunk of cash with a first-time fund with a focus on US buyouts in the current environment is also questionable. USS is invested in a number of European buyout funds and may be underexposed to the US mid-market but this decision certainly looks like a brave one. It also runs counter to the Coller findings where respondents placed North American buyouts fifth in the list of most attractive opportunities for investment over the coming year, behind Asia-Pacific and European venture.

The LP love affair with private equity is a confused one.

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• LPs
• UK / Ireland