Mumbai: Private equity (PE) funds may be breathing easier now, what with liquidity easing and credit lines opening up, but investors in such funds, otherwise referred to as limited partners, or LPs, feel that things are going to get worse before they start getting better, shows a survey by Coller Capital, a London-headquartered PE investor.
Dried funds: Pinal Nicum, principal at Coller Capital.
The six-monthly survey by Coller, released earlier this month, and titled Global Private Equity Barometer, gives a snapshot of investor views on the markets and outlook for PE funds. The latest round of the survey had 120 respondents, including pension funds, sovereign wealth funds, insurance companies, endowments and investment offices of large business families.
“A couple of things stood out (in the survey). Firstly, investors quite clearly understand and feel that things are going to get worse before they start getting better. The other is that there’s likely to be some change in the private equity landscape over the next period going forward,” said Pinal Nicum, principal at Coller Capital, speaking about the findings of the report from London.
Trough before the crest
Illustrating this is the fact that around three-quarters of the investors surveyed expected distributions from their portfolios, or what they receive as returns from their fund managers, otherwise referred to as general partners (GPs), to deteriorate over the next year. This is the most gloomy LPs have been since the Barometer was first compiled in 2004.
“Two-three years ago, there were obviously lots of transactions and exits happening, and the IPO markets were open for deals to be exited. Clearly, over the last 18 months, that has all dried up and the amount of cash coming out of underlying funds has dried to a trickle. The LPs are not seeing that improve any time soon,” said Nicum. IPO is short for initial public offer or a first share sale by a company on public equity markets.
Around three-quarters of the investors surveyed expected distributions from their portfolios, or what they receive as returns from their fund managers, otherwise referred to as GPs, to deteriorate over the next year. Ahmed Raza Khan / Mint
The survey comes at a time when secondary transactions, or secondaries, which are deals in which an LP sells its position in a fund to another LP in order to create liquidity for itself, are gaining momentum, though not too many of such transactions have been inked given mismatch in expectations on valuation.
While secondaries are done for a variety of reasons, including an LP not wanting to wait till the end of the life-cycle of a fund, typically 10 years, to book profits, there has been renewed vigour in the secondaries market ever since the global credit crisis hit home some nine months ago.
With this, some LPs that have been too capital-constrained to meet their commitments to PE funds have sought to sell these commitments or positions to secondary specialists. Also, 76% of the respondents felt that valuations of their underlying fund portfolios at the end of 2009 will be significantly lower than those reported in December 2008.
“They are not expecting availability of capital to improve either, whether that’s underlying funds doing deals or whether that’s for themselves investing in those underlying funds,” said Nicum. Illustrating the latter is data that shows 84% of LPs declined to re-up or reinvest with one or more of their existing GPs over the last 12 months.
On the second point, of how the PE landscape will change, around half the respondents felt that changes to regulations and taxation are likely to damage the business’ wealth- creating potential in developed markets in next two years. Also, those surveyed believed that almost a quarter of the existing GPs would not be able to raise a fund in the next seven years, and that they’ll go out of business.
A third factor that stands out in the report is that buyout funds—PE funds that typically use debt significantly in deals—have made the most significant contribution to LPs’ returns. That rather goes against a counterview that there’ll be a shakeout in the buyout world.
A December 2008 report brought out by Boston Consulting Group and Spain’s IESE Business School indicated that at least 20% of the 100 largest leveraged buyout PE firms— and possibly as much as 40%— could go out of business within two to three years. “More disturbingly, most PE firms’ (referring to buyout funds) portfolio companies are expected to default on their debts, which are estimated at about $1 trillion (Rs48.20 trillion),” the report had said.
Nicum, however, explains that the Coller report is in no way contradictory to the view that there’s going to be a shakeout in buyout managers.
“People have expressed concerns about where the buyout community is heading, and among our deal flow right now, we’re certainly seeing a lot of people trying to sell positions in the large buyout funds,” he said. One reason is LPs have made very large commitments which they cannot fund any more, and the second that those underlying funds have been invested in very heavily leveraged businesses. So, going into a downturn, they’re looking at those funds and thinking performance is not going to be adversely affected.
Nicum adds that a couple of factors could play into why LPs say that buyout funds have delivered higher returns thus far.
“Buyouts have been a large proportion, particularly for Western investors. There’s a causal link you would have there with the kind of returns they are getting out of those. Also, it’s fair to say that in the last cycle—between 2002 and 2007—buyout firms, particularly in Western Europe and the US performed spectacularly well. Anyone who had exposure to that vintage of funds will have seen exceptional returns from there in their overall private equity book,” he said.
He says it’d be interesting to see the answer to that question (which type of fund has delivered the maximum returns?) if you asked people in three years’ time. Perhaps, the hits they’ve taken in their recent buyout funds would mean that their investments in venture or growth capital funds, could be contributing more to returns.
The India angle
While the survey does not demarcate preferred PE destinations for LPs, Nicum said that there is no question that India and China both remain attractive to PE investors.
“Whether this interest translates into commitments to Indian funds in the next 18-24 months, though, remains to be seen. It is less a question of whether investors have the appetite for investment than of whether individual investors have capital available to commit,” he said.
And as is evident from the survey, with capital scarce, LPs are becoming more selective about the GPs they will back. “In the next fundraising cycle there will be a flight to quality, or at least to perceived quality. This will be a global phenomenon. However, in emerging PE markets such as India, judging manager quality is something LPs will find particularly tricky given the relatively short track records of most GPs,” he said.