Today’s sophisticated institutional investors are increasingly looking for higher and more consistent returns than can be typically achieved through traditional investments in bonds and equities. Therefore, many are increasing their allocations to alternative assets, including real estate, infrastructure, hedge funds, private equity and private debt (for simplicity’s sake, let’s refer to the latter two together as “Private Equity” or “PE”).
With these growing allocations to the Private Equity asset class, investors (often called “Limited Partners” or “LPs”) are driving the significant growth with their increasing capital commitments to PE funds. This increase in capital to the asset class has substantial consequences for both expectations of risk and returns, and the way the due diligence process is conducted on PE fund managers’ (also known as “General Partners” or “GPs”) track records.
In addition to the overall asset class growth, LPs are also seeking more diverse ways to deploy their capital to Private Equity with the aim to optimize their potential returns. Besides the traditional fund and fund-of-fund structures, an increasing number of LPs are now demanding specialized mandates, co-investment rights and sometimes joining syndications of direct deals.
These structural market changes have led to a growing number of GPs who can offer far more diverse strategies to invest in private companies. Along with this diversity of investment structures comes increased complexity which demands more rigorous due diligence on the part of LPs.
CEPRES is explicitly designed to handle this growing, complex Private Equity landscape so you can have increased transparency, a better understanding of both the risks and returns and therefore, make more informed investment decisions with higher due diligence process efficiency.
A crowded private equity market creates more pressure
With the growing appetite for the Private Equity asset class, naturally, there is also a growing number of GPs appearing in the market. Logically, this trend results in more competition for deals (i.e. the underlying investments in portfolio companies by Private Equity funds), which means there are more players with dry powder (i.e. capital available to invest) chasing after the same deals.
This competitive dynamic can result in challenges to GPs such as the pressure to deploy capital during the lifetime of a fund. GPs operate these Private Equity funds which have predefined Investment Periods that stipulate that the fund must fully invest its capital within a certain timeframe (usually 3 to 5 years).
The pressure to compete for and invest in deals can manifest as upwards pressure on entry valuations (or pricing) of companies, the amount of leverage applied to the transaction and potentially shortcuts in the due diligence process by the GP on prospective deals. All of these factors can ultimately contribute to downward pressure on returns for LPs.
For LPs, it’s all about sifting through the noise and complexities to accomplish these 3 key goals:
Understanding the risk-return profile and characteristics of the different strategies within the Private Equity market, and determining which of these would fit into your portfolio to enable you to achieve your target returns
Target and connect with the right GPs operating in the market segments that you have identified, thereby staying focused on the real opportunities
Perform the highest quality and most sophisticated due diligence on GP track records to provide transparency and a clear understanding of the risk-return profile of specific GPs before committing to a fund, all the while achieving maximum operating efficiency with your own internal resources
CEPRES leverages its innovative technology and investment expertise to support LPs in accomplishing these 3 important goals. Join now for free and find out more >>
Market cycles and illiquidity
As with all asset classes, Private Equity exhibits cycles that can influence the outcome of investments based on the timing of capital within an up or down cycle. Each Private Equity subclass also exhibits its own cycle and varying correlations to other markets. For example, Buyouts tend to track public markets (with some inherent lag effect), whereas Private Debt rather tends to counter-correlate to public markets and thus can act as a hedge against volatile or falling markets.
The impact of market cycles on Private Equity is even more challenging because most Private Equity investments are illiquid in nature. There is currently very limited access to secondary trading markets for either funds or deals. Having said that, there are dedicated secondary buyers (or secondary funds) whose sole strategy is to seek, negotiate and transact on secondary Private Equity assets (these can be LP positions in PE funds, fund-of-funds, co-investments, direct investments and essentially any other existing asset in the Private Equity market).
These secondary buyers can acquire single assets or entire portfolios or parts thereof, but they almost always demand deep discounts that can wipe out any gains of the seller. Plus, these secondary transactions are not conducted out in the open market, but rather negotiated on a bilateral basis between the seller and the secondary buyer. So the secondary process itself can take a lot of time, perhaps several weeks or even months since lawyers are involved with the transaction.
In other words, once you commit and invest in Private Equity, you’re in. You can’t just call a broker or go online to instantly sell your positions like you would for publicly traded stocks. So, yes, Private Equity is illiquid.
What does this mean for LPs? You invest in Private Equity for the long haul, and therefore, you need to do your homework thoroughly before you invest.