Schroder Adveq outlook for private equity 2018
- We maintain a positive outlook for new capital commitments to private equity in 2018
- A vast universe of thousands of funds - often specialized - offers a broad choice to investors
- Large buyouts and “unicorns” are currently the segments most exposed to valuation risk
- The best risk/return opportunities are in segments with high barriers to entry
Asset raising expected to continue at a strong pace
Private equity1 has played an increasingly important role in portfolio allocations for many institutional investors. We expect that this trend will continue in 2018, leading to another record year for private equity fund raising.
Recent surveys2 show that 95% of respondents are either satisfied or highly satisfied with the performance of their private equity investments. According to the same surveys, private equity investors typically expect long-term private equity outperformance over listed equities of 2-4%, and in some cases even more.
Investors are attracted to this asset class for a number of reasons. Investors expect certain private equity strategies to have lower volatility than listed equities. Private equity is also expected to have a low correlation with traditional asset classes and thus to deliver positive diversification effects. Finally, private equity allows investors access to sectors or industries that cannot be accessed through other asset classes.
A few mega funds and thousands of specialized funds
The private equity fund manager universe has grown to more than 4,000 firms3 , consisting of buyout, venture capital, growth capital and turnaround focused fund managers. We expect it to continue to expand in 2018. We expect continued growth in fund sizes which, as in the past, is likely to be concentrated in about 15-20 “mega” fund managers.
In 2017 two fund raising records were broken. The $100 billion Softbank Vision Fund became the largest private equity fund ever raised and the $24.6 billion Apollo Fund IX became the largest ever buyout fund. We believe that it is likely that we will see more fund raising records being broken in 2018.
The segments most exposed to valuation risk
The rising interest in private equity is encouraging, but this “frothy” environment also creates challenges. Some parts of the market - especially the segments where the “mega” fund managers are most active - have a lot of committed but undrawn capital, or “dry powder”.
This has already led to historically high valuation levels in those segments where general partners are competing for the same transactions, especially when it comes to large buyouts. There is a similar situation for pre-IPO technology companies - so-called “unicorns”4 - where significant amounts of capital have been deployed by non-traditional private equity investors. Debt financing for buyout investments at the large end of the market is also currently widely available, which further contributes to high valuation levels.
We believe that investors should exercise caution with regard to the risks that arise from elevated valuations and debt levels in these segments. Furthermore, as more and more investors embrace private equity and other illiquid investments, there is also a question as to whether the illiquidity premium that investors have historically expected to realise from their illiquid investments may diminish over time.
1 Private equity is defined as investment in privately held companies that are actively managed by professional fund managers (typically referred to as “general partners”)
2 Source: Preqin institutional investor survey, 2017
3 In addition, there are another 12,000 fund managers in China that are only accessible to Chinese investors
4 Defined as privately-held venture backed companies with more than $1 billion enterprise valuation