Shifting PE dynamics: what do the LPs think?

Despite there being no obvious macro storms on the horizon, there are still some shifting dynamics within the private equity industry.

What are they, and how are LPs dealing with them? Was there any shift in LP expectations of GPs? Could they be doing something different – better, even?

One obvious dynamic that LPs are grappling with is the continued increase in asset prices, “everything is getting expensive,” as one panel member at SuperInvestor 2017 in Amsterdam succinctly put it.

You might expect that, as a result, investors would be reassessing return expectations – but that isn’t the case. How could the panel of LPs explain this?

Return expectations are a product of objectives: It’s hard to get a one size fits all answer.

Christian Kvorning, Investment Director at PKA AIP, said that it was down to general economics, as well as human behaviour: “It’s a reflection of recent returns,” he said. “People extrapolate returns based on the recent past. As we all know, it’s a cyclical business. A down year follows a down year, and an up year is followed by a up year.”

But he added a note of caution: “After a long time it seems that we have a slight down year, and that should make us all stop and wonder.”

Jim Strang, Managing Director at Hamilton Lane, argued that return expectations were a product of objectives: “It’s hard to get a one size fits all answer,” he said. “If we have someone shooting for super alpha and it’s Dutch turnaround funds, they’re up here, if it’s trying to replace a corporate credit portfolio, it’s down here,” he stated.

Eric-Jan Vink, Head of Private Equity at PGGM Investments, added that: “LPs have a tendency to keep return expectations flat. Anecdotally, what we are seeing is a shift in risk appetite to get to that level of return. That means more leverage introduced into deals and structures.”

What to expect from GPs

Eric-Jan had a big focus on the operational capabilities of GPs, because most base cases now show lower multiples. “GPs are not counting on any multiple uplift, that means that you have the operational change or impact, so there’ll probably be a bit more execution risk, whether that’s re-positioning the company or executing M&A strategies. We carefully consider whether we are confident they can handle and manage those transition periods.”

For Rune Jepsen, Principal, Global Private Capital at QIC it was all about risk management: “We would hope GPs are maintaining a fairly level assessment of risk that looks across the cycle. I hope they are prepared to disappoint in terms of volumes they are executing on, with the intention of keeping a steady approach to risk management.”

The era of increasing fund sizes made Eric-Jan wary: “We do not want to commit to a fund or a manager who can’t manage an increase in size of funds. We believe a bit of growth is good but it should be within range.”

In addition, he’d like to see a reduction in the use of credit-lines. “It really changes the economics,” he explained. They were also planning  to continue to focus on co-invest, “so we can try and make a difference there ourselves.”

A shift in fees?

One area where there hasn’t been much of a shift in the industry is in fees. That’s despite there being a real focus in recent years on altering structures; co-investment and special accounts, for instance.

"Think about the range of options that you’ve got and what your options are and toggle according to that. Don’t think about private equity, it’s a mile wider than that."

However, Christian explained that they tackled the issue of fees by spending time uncovering other fee streams. “We’re very focused on the offsets and how they work. Quite often we’re not happy and the funds don’t pass our initial screens or due diligence because of the offsets,” he said.

Most of the panel were pessimistic about any fundamental fee shift, arguing that if the great financial crisis hadn’t done it, nothing would. But Eric-Jan felt that the next downturn might play out differently and put pressure on the model.

Looking forward, whilst the LPs admitted they were benefiting from the increase in capital and solutions available, challenges remained: “The issue is to assess which parts make sense and which don’t,” said Rune.

Jim concluded the session with some advice: “Think about the range of options that you’ve got and what your options are and toggle according to that. Don’t think about private equity, it’s a mile wider than that. Look at Blackstone and their real estate business. Do you really know how to pick credit? Do you really know how to integrate real assets? Do you really have all that figured out? And can you piece it all together in a logical way?”