While the public markets haven’t been too keen on private-equity firms lately, the investors who put their money into such vehicles are showing renewed confidence in them. That suggests that financial sponsors will continue to play a strong role in maximizing the returns from assets, injecting distressed companies with new life, taking public firms private, and consolidating smaller players in certain industries. And they will have plenty of dry powder to bid up the price of companies and assets for the next few years.
Private-equity fund-raising accelerated in the second quarter, according to a survey of 100 limited partners (LPs) by Preqin, an alternative-asset research firm. Three hundred and eleven private-equity funds closed in the first half of 2011, raising an aggregate $142 billion, a little more than half the total raised in all of 2010. Almost two-thirds of the limited partners polled made new commitments in the first half, up 10 percentage points from last year, says Preqin, and 57% plan to do so before year-end. Almost half (46%) of LPs say they would commit more capital to private-equity funds this year than last.
It’s not surprising that investors are pouring money into private equity. During the past four years, a number of issues had kept a lid on inflows. First, in 2009 and 2010, most institutional portfolios shrank, so they didn’t have any capacity for new investments, says Steven N. Kaplan, a professor of entrepreneurship and finance at The University of Chicago’s Booth School of Business. The phenomenon is known as the denominator effect: when the value of investments like stocks and bonds falls and causes losses, investments in other asset classes, like private equity, rise above allocation targets, requiring adjustment of the portfolio.
Second, investors were very concerned about liquidity, after finding themselves overcommitted to illiquid assets in 2008. Third, there just weren’t as many private-equity funds raising money in 2009 and 2010, after having amassed a ton of capital in 2008.
What’s different this year, Kaplan says, is investors have figured out the liquidity problem, portfolios performed well in 2009 and 2010, and more private-equity funds are out raising funds. What’s more, “the performance of PE historically has been terrific,” says Kaplan. “There was a little bit of scare in 2009 when things were illiquid, but when you look at funds raised in 1993 to 2005, all those vintage years did very well relative to public markets. The LPs are back and I expect that to continue.”
What kinds of funds are attracting the dollars? Forty-nine percent of LPs say small-to-midmarket buyout funds offer the best opportunities, and 23% name distressed-asset funds. Emerging markets are also still attractive: 61% of LPs plan to increase their allocations to emerging markets in the long term, the survey says, with Asia seen as presenting the best opportunities. South America, particularly Brazil, is the next geography on investors’ radar screens.
Kaplan says the trend toward middle-market funds is “sort of the belief of the day.” “People tend to herd,” he says. “In the late ’90s, everyone wanted to be in venture, and in 2007, everyone wanted to be in private equity. Now everybody wants to be in the middle market. The risk is you get too much money [coming in].”
Most LPs said private-equity investments have lived up to their expectations. About 90% expect private-equity portfolios to return at least 200 basis points above public-market yields, according to the Preqin survey. A full 70% anticipate an even bigger reward for the risk, aiming for a yield 400 basis points above public-market benchmarks.
“You never can tell, and it varies with vintage year,” says Kaplan, “but the 200 basis points is not crazy. Two hundred basis points would be in the historical ballpark.”