Outlook for private equity in 2023
September 2018 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2018 Issue
It is perhaps a cliché to say that ‘alternative’ assets is a title that no longer fits the private equity (PE) industry, but it is true nonetheless. Four out of five institutional investors now invest in at least one alternative asset class, and more than half invest in three or more. For PE specifically, almost six out of 10 institutional investors have some allocation to the asset class, and this figure seems set to rise further in the coming years.
We can expect this transition of alternative investments towards the mainstream to continue over the next five years, and perhaps even pick up its pace. Already, we have seen 2017 set a new fundraising record, breaking a barrier that had stood for a decade. PE funds closed in the year secured $527bn, breaking the half-trillion-dollar mark for the first time and surpassing the previous record by around $75bn. This is reflective of the regard with which investors view alternative assets: almost two-thirds said they had a positive perception of PE at the start of 2018, and 53 percent are planning to commit more to the asset class over the next year. In fact, by 2023, 79 percent of investors expect to have higher allocations to PE than they do today, and 84 percent expect the same for alternative assets generally.
Appetite for PE investments is based on the benefits that appeal to investors. PE offers them portfolio diversification, low correlation and volatility compared to other asset classes, absolute returns and a hedge against inflation. These advantages are particularly appealing when considering that half of investors currently believe that public markets are due for a correction within the next 12 to 36 months. Still, it is equally true that the long-term performance of PE, regardless of the headwinds in other asset classes, is a powerful draw for institutions which are frequently pursuing increasingly demanding returns objectives.
These conditions are already apparent in the PE industry, but we expect them to become ever-more-powerful influences. PE assets under management have been spurred on by booming appetite, and as of the end of 2017 the industry crossed the $3 trillion mark, holding $3.06 trillion in assets under management (AUM) and potentially even more in shadow capital. With most investors looking to raise their allocations and commit more money to the asset class than ever before, we anticipate that the total assets held by the industry could rise to around $5 trillion by 2023.
However, it is likely that the distribution of capital across the industry will be significantly different than it is today. When asked how they believe their assets will be balanced in 2023, almost half (45 percent) of fund managers said that they expected to hold less of their overall assets in pooled funds than they do currently. By contrast, large proportions of both fund managers and investors expect that they will hold more capital in alternative structures like joint ventures, separate accounts and co-investments. The latter in particular seems set for growth, with the largest proportions of both managers and investors – 42 and 34 percent respectively – expecting co-investment assets to increase.
This may well place more negotiating power in the hands of investors, as fund managers look to offer more tailored solutions. The ability to negotiate co-investment rights or separate account terms will swing in their favour if fund managers start competing more intensely to offer these kinds of services. However, they remain for the time being largely the preserve of only the largest investors or fund managers – the infrastructure and scale necessary to implement them is beyond the reach of most participants.
At the same time, corporate and institutional investors are likely to become more central competitors to PE funds when it comes to dealmaking. While some of the largest investors have previously made direct investments in asset classes like real estate, we are increasingly seeing both institutional and corporate investors become more active in the private equity space as large investors. In some cases, corporate investors like Softbank, Google and Alibaba have even raised their own PE-style funds to compete with traditional fund managers. As institutions bring more investment expertise in-house, it is likely that this trend will continue, particularly in Asia as large corporate investors become more active. It is possible that this will put sustained pressure on dealmaking markets. Already there are concerns about asset pricing in some quarters, and with deep-pocketed new entrants to the market, those pressures are unlikely to abate in the medium-term. Fund managers will increasingly have to specialise, innovate and cultivate networks in order to ensure that they maintain a pipeline of potential investment opportunities at attractive price-points.
On the other hand, other investors are set to become more important sources of capital for the industry as they increase their allocations to traditional fund managers. Fund managers expect North America- and Europe-based investors to remain broadly the same in terms of how much capital they represent over the next five years. The majority (60 percent), though, expect to see increases from Asia-based investors, making the region an important source of future capital. The rise of Asia as a major market for private equity funds and deals has been ongoing for several years, but there remains a lot of untapped potential from institutional investors based in the region.
Fund managers also expect to see changes in the balance of different investor types contributing to the industry. Despite recent deregulation in the US, 41 percent of managers think that less capital will be sourced from banks in 2023 than it is today. A similar proportion (40 percent) expect that funds of funds will become less significant – whereas they previously provided investment expertise to investors of all sizes, increasingly their attraction is focused on offering smaller investors access to top-tier commingled funds and diversification across different strategies.
By contrast, family offices, sovereign wealth funds and foundations are all anticipated to become more important sources of PE capital: 65, 50 and 49 percent respectively of fund managers expect to receive more capital from them in 2023 than they do in 2018. The number of family offices incepted globally is expanding rapidly, and many have very high allocations to alternative assets, making them among the fastest-growing sources of capital. Sovereign wealth funds, although small in number, are generally extremely large investors, and increases of a few first-time investors or small allocation changes could equate to billions of dollars flowing to the industry. Many do not invest at all in PE at present, but there are moves at some institutions for them to become active contributors. For instance, Norway’s Government Pension Fund Global recently applied to start investing in private equity, a move that was only narrowly defeated in the Norwegian parliament. If they ask again and are granted permission, the $1 trillion sovereign wealth fund could invest hundreds of billions of dollars in the industry.
Ultimately, PE seems set to record significant further growth over the next five years, and could have grown by 50 percent by 2023. Investors are generally enthusiastic about committing to the industry, and the underlying appeal of the asset class only looks set to become more pronounced in the coming years. However, the balance of power between investors and fund managers should shift significantly as investors keep bringing more functions in-house, and we could see more focus put on alternative methods of accessing the asset class as fund managers look to cater to investors’ needs.
However, the commingled fund market is far from waning – new investors are establishing commitments to the market every year, and in this the cliché is to the favour of PE. Once seen as a risky alternative to other asset classes, PE is now a staple of many investors’ portfolios and seems likely to be added to many more, providing fresh sources of capital for years to come.
Christopher Elvin is head of private equity at Preqin. He can be contacted on +44 (0)20 3207 0256 or by email: celvin@preqin.com.
© Financier Worldwide
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Christopher Elvin
Preqin