Is Private Equity Really Illiquid? by Preqin
Private Equity Fund Manager Outlook for 2016
In this extract from the 2016 Preqin Global Private Equity & Venture Capital Report, we take a look at fund managers’ views on the current issues affecting the industry and their outlook for the year ahead, based on a survey of 330 fund managers.
In Brief
- Valuations are the primary concern for North America- and Europe-based fund managers in 2016, while fundraising is viewed as the biggest challenge for managers outside these regions.
- The majority of fund managers are looking to increase or maintain the amount of capital deployed in private equity investments over the next 12 months.
Key Issues
Valuations are seen as an important issue by fund managers for private equity in 2016, with 40% of all respondents concerned about the price of portfolio companies. This issue has seen an eight percentage point rise from last year, overtaking fundraising to become the greatest challenge that fund managers face in 2016. However, as Fig. 1 shows, there is signifi cant variation geographically in the perception of the biggest challenges facing GPs in 2016. Of the North America-based GPs surveyed, concern over valuations outweighed any other issue by some margin, while a more equal proportion of Europe-based GPs highlighted a wider range of issues as their area of primary concern, including valuations, fundraising, performance and regulation. Asia- and Rest of World-based managers however, appear far more apprehensive about fundraising, with 54% and 57% of respondents selecting this issue respectively. As confirmed by Preqin’s LP survey results, the fact that the majority of LPs believe the more developed private equity markets are the regions presenting the best opportunities, combined with the rise of ‘unicorn’ valuations and greater competition for deals, perhaps goes someway to explain this geographic variation.
Performance, regulation and the ongoing volatility and uncertainty in global markets were all selected by significant proportions of fund managers, with Asia-based managers unsurprisingly the most concerned about the global economic outlook moving into 2016. Europe-based managers were the most concerned about regulation, highlighting the long-term impact of the AIFMD and other regulation on the European private equity market. Additionally, 29% of Asia-based fund managers were concerned about exits, a larger proportion than in the other regions, possibly due to economic fears and the difficulty of pulling off a successful IPO.
With valuations cited as the largest challenge for the coming year, this suggests that private equity managers have been struggling to find the best investment opportunities at the right prices. When asked about the difficulty of sourcing attractive investment opportunities compared to 12 months ago, 38% of fund managers expressed that it is more difficult now than the previous year. Only 9% of respondents suggested that it is now easier to find attractive opportunities, the same proportion seen in last year’s survey. Over half (51%) of fund managers stated that they have seen no change in the difficulty of finding attractive deal opportunities, despite widespread concerns over valuations.
In spite of this, the majority (60%) of fund managers expect to increase the amount of capital deployed in private equity assets in the next 12 months. As shown in Fig. 2, Rest of World-based fund managers are the most likely to increase capital in private equity assets, with 61% suggesting they will deploy significantly more capital in 2016 than in 2015. This is compared with just 20% of North America-based managers, while just 10% of all managers globally stated they are expecting to deploy less capital in the upcoming year.
Investors and Fundraising
As shown in Fig. 3, two-thirds of respondents have seen an increase in competition for institutional investor capital in the past 12 months, with just 3% of fund managers witnessing a decrease. This helps to explain why fundraising remains one of the greatest concerns for GPs in 2016, with a belief that securing capital is getting harder and harder. Such sentiment is reflected in the funds in market levels too, with 2,651 private capital funds in market as of January 2016, the highest ever number.
With constantly evolving LP preferences and greater competition for capital, GPs are further looking to differentiate themselves. Environmental, Social and Corporate Governance (ESG) factors for example have grown in importance for fund managers, as investors want to know if there are any risks tied to the companies in which their capital is being invested. Of the fund managers Preqin surveyed, 35% consider ESG factors for all deals they make, with another quarter doing so on a portion of deals (Fig. 4). For those fund managers that do consider ESG factors, the vast majority focus on environmentally responsible (76%) and socially responsible (73%) investments, compared with just 13% and 11% of respondents that expressed an emphasis on women-owned and minority-owned companies respectively. Sustainability is becoming increasingly important to the private equity industry – a sophisticated step that shows LPs how fund managers are carefully considering which investments to make while thinking about the wide-reaching impact such investments will have.
Another way in which GPs can try to tackle the increased competition for LP capital is to alter the way LPs can gain access to the private equity asset class. Thirty-four percent of fund managers stated that they plan to offer investors more opportunities to invest via separate accounts in 2016, with just 5% claiming they will offer fewer such opportunities. Alternative ways to access the asset class are becoming ever more important as LPs are trying to put record distributions back to work, with these routes explored further in the 2016 Preqin Global Private Equity & Venture Capital Report.
In the face of increased competition for investor capital, GPs are also seeing a general increase in investor appetite for private equity as an asset class. As shown in Fig. 5, respondents perceive there to be a greater proportion of LPs with more appetite for private equity than less appetite compared to a year ago. Of particular note is the fact that more than half (56%) of GPs stated that family offices have an increased appetite for the asset class, with just 8% of GPs noting a reduction in appetite among this investor type.
In terms of the regions managers are targeting for investor capital, the vast majority are looking towards domestic LP capital, as can be seen in Fig. 6. Interestingly, just 12% of Rest of World-based fund managers are seeking Asia-based LP capital, while almost three-quarters of these fund managers look towards North America- and Europe-based LPs when raising a fund. Despite the introduction of the AIFMD regulation, 41% of North America-based fund managers will consider Europe-based investors when raising capital for a fund.
Regulation
As new regulation continues to take shape in the private equity industry, we asked fund managers for their opinions on how regulation will affect the asset class in 2016, with 45% claiming that there will be no change as a result (Fig. 7). Only 15% of respondents thought that there will be a change for the better, with the remaining 39% expecting regulation to affect private equity for the worse.
Specifically focusing on the AIFMD, 47% of respondents that are targeting Europe-based investors cited the cost of compliance as their primary concern, with a further 28% stating that the AIFMD regulation increases the complexity of the private equity market (Fig. 8). Additionally, when Preqin asked fund managers that were already compliant with the AIFMD how they were finding the compliance costs, 39% felt that costs were higher than expected, with just 1% experiencing costs lower than anticipated.
Outlook
A quarter of fund managers surveyed were in market with a private equity fund at the end of Q4 2015, with a further 34% planning to launch a vehicle in 2016 (Fig. 9). While the private equity model appears to be working and helping to drive investor appetite for the asset class, concern remains in the crowded fundraising market, particularly for less established GPs, as fund managers strive to stand out from the crowd to secure LP capital. Fund managers will be hoping to put more capital to work in 2016; however, the record levels of dry powder that have accumulated over the past few years are likely to mean little reduction in competition for assets at attractive entry prices.
Is Private Equity Really Illiquid?
– Philippe Jost, Vice President and Mauro Pfister, Senior Director, Capital Dynamics
Private equity funds generally have a contractual initial life of 10 years – most often in the form of a limited partnership or equivalent vehicle. The first 5-6 years correspond to the fund’s investment period, during which the fund manager can draw down capital committed by investors. Thereafter, the manager can generally no longer draw down unused committed capital other than for fees, expenses and follow-on investments. As soon as investments are realized (underlying companies are sold or liquidated after going public), the capital and profits are distributed to investors. The timing of the drawdowns and distributions is completely out of the control of the limited partners. In addition, there is no way of liquidating the partnership interests without a transaction on the secondary market.
This illiquidity is one of the major perceived risks when considering private equity as an asset class in which to invest. Certainly, the risk of loss associated with selling partnership interests on the secondary market at a discount on the reported NAV is high. By means of historical simulations, this article shows that despite being illiquid, private equity funds are self-liquidating i.e., after a certain number of years, the net cash fl ow is positive while the net asset value decreases.
An investor with a mature portfolio can consider its private equity portfolio as partially liquid. Capital Dynamics has extensive experience in using simulations to help investors estimate the average future capital calls and distributions as well as understand the risk associated with the uncontrollable nature of private equity cash flows.
Self-Liquidation of Private Equity
For our analysis, we simulate a portfolio of a fictitious investor who commits to private equity regularly and in a diversified manner. Therefore, it makes sense to use pooled cash flows per vintage year to approximate the private equity portfolio; the Preqin1 database has been used for this purpose. Fig. 1 shows the evolution of the net cash fl ow of portfolios committing $1mn per year during 10 years. Each black line represents the quarterly net cash fl ow evolution of a portfolio with different starting vintage years ranging from 1986 to 2005. The green line represents the average case. Typically, the investor needs less than $4mn to finance this investment strategy and after 7-8 years the portfolio starts to be self-financing i.e. the distributions are larger than the capital calls. Some scenarios are self-financing in later stages and also have higher financing costs.
This article focuses on the period that is not displayed in the previous figure. What happens to the NAV and to the net cash flow if an investor suddenly decides or is forced (for any given reason) to stop committing to private equity? Considering the situation depicted in the previous graph, we expect the portfolios to be self-financing after 7-8 years.
Fig. 2 shows that after investing in private equity for 10 years, the portfolio typically generates sufficient cash to be self-financing for the rest of its life. The asset base slightly increases during the first 1-2 years because the last committed funds are still building exposure and then steadily decreases thereafter. The annual distributed cash is close to 20% of the starting NAV. On average, the portfolio pays out 100% of its starting NAV after 4-5 years. These numbers precisely explain what we would like to highlight about private equity: despite being illiquid, it is self-liquidating.
The number of years during which the investor commits to private equity has a profound impact on the cash fl ow profile during the liquidation period. For a small number of commitment years, most of the funds are still in the investment phase and are drawing capital from the investor. Therefore, the portfolio is not likely to be cash fl ow positive. This situation is depicted in Fig. 3, where younger portfolios are illustrated with colored lines. The cash fl ow patterns for more mature portfolios are depicted in black. After five years, an investor has already built a portfolio that is close to being self-financing. We, therefore, advise investors to commit over a minimum of five consecutive years to ensure that a decision to stop investing in private equity will not automatically necessitate a sale of the portfolio due to cash fl ow requirements.
Optimize Liquidity Management with Simulations
When a private equity portfolio ages, it tends to become self-financing. However, it may take some time to reach this state and even a mature portfolio might experience years where the sum of the capital called is larger than the distributions. Therefore, prudent investors need adequate risk management tools allowing them to quantify the liquidity requirements in adverse situations. Cash flow simulation fulfills this purpose.
Modelling the cash fl ow of a private equity portfolio is challenging and there are several different models. The simplest models generally use shape functions that represent the future cash flow as a single smooth line for each fund. This approach disregards the variability of the cash flows and focuses solely on the average case. This limitation can be overcome by using Monte Carlo methods based on historical private equity data. The simulations can be enhanced by taking the relationship between private and public equity into account. For each run of the Monte Carlo method, a unique simulated public market environment can be used to scale the distributions and the NAV of the private equity portfolio. Fig. 4 shows an example of a simulation for a portfolio invested over three years in US buyout funds (three funds per year).
The net cash fl ow chart of the portfolio of primary funds illustrated in Fig. 4 is a powerful tool to derive the liquidity requirements in various scenarios and especially in adverse situations. Different hypotheses about future commitments can be added and compared. Therefore, the simulations can also be used to optimize future commitments (funds’ geographies, styles and ticket sizes) in relation to the expected liquidity generated by a portfolio and the specific requirement of an investor.
Conclusion
The observation that a mature private equity program generates significant cash (i.e. on average 20% of the NAV after the last commitment year is distributed annually) should alleviate the often perceived concern that private equity is an illiquid asset class. On average, a mature portfolio pays out 100% of its NAV after 4-5 years. These figures support our belief that despite being illiquid, private equity is self-liquidating. This has noticeable implications for different types of investors.
We have shown that a consistent method for new investors to enter the private equity asset class is to commit regularly during approximately a five-year period. This will lead to a portfolio that is approaching self-liquidation, and while still being relatively immature, it is possible to assess its performance. By definition, long-term investors are convinced by the advantages of investing in private equity. They are more sensitive to the fact that their holding would be able to generate a sufficient amount of cash in a reasonable timeframe if needed. Both existing and new investors can benefit from cash fl ow simulations as they quantify the cash requirements (on average) to design the commitment pacing or to evaluate the risks in difficult market environments.
Make-up of LPs in Recently Closed Funds
Utilizing data from Preqin’s Investor Intelligence on Private Equity Online, we examine the make-up of investors in funds closed over recent years.
In Focus: African Private Equity
Africa-focused private capital funds collected a record $5.7bn in 2015, of which Africa-focused private equity funds accounted for $4.5bn. Ayush Varma uses Preqin’s Private Equity Online service to examine the ebbs and flows of private equity fundraising in Africa.
Performance: Asia- & Rest of World-Focused Funds
Asian Buyout Deals
2015 saw the highest annual aggregate value of private equity-backed buyout deals in Asia. Wilson Su takes a closer look at the figures.
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