Perspectives from the 2018 SuperReturn Private Equity conference

The private equity industry is clearly on a growth trajectory, however, private equity managers recognize that both challenges and opportunities lie ahead.

Market dynamics 

Equity valuations are at record highs, the result of a combination of factors, including high levels of cash reserves (sitting at approximately USD 1.7 trillion as of December 2017),¹ low-cost financing, growing competition from cash-heavy acquisitive corporations, and large direct investors. 

Some experts at SuperReturn noted that acquisitions in the US and Europe were being priced between 10 and 13 times EBITDA (earnings before interest, taxes, depreciation, and amortization). While such valuations may deter some investors, it may provide deal-hungry private equity managers with an opportunity. 

Another opportunity lies in the largely untapped ecosystem of disruptive technology firms, such as artificial intelligence providers, that have yet to appear on private equity buy lists. This theme was further explored in a panel session moderated by Dirk Holz, head of origination and business development, private capital services at RBC Investor & Treasury Services. Read more in Investment opportunities in AI.

Lucrative returns are also potentially available to private equity managers willing to invest in technology firms focused specifically on financial services, said one manager. Holz also identified disruptors in the payments industry and capital markets sector as being among the most promising revenue sources in the sector.

Fees: not a time for complacency 

Despite reports indicating that fundraising has never been more straightforward for private equity,² investors should not be taken for granted. As clients become increasingly institutional, managers are beginning to disclose more business information in order to win and retain mandates. Fee transparency, either through tailored reports or standardized documents produced by the Institutional Limited Partners Association, has become industry standard. 

While investors are critical of fees, specifically carried interest costs, it appears very few Limited Partners (LPs) are applying cost pressures when compared to the hedge fund and traditional asset management industry. Several LPs at SuperReturn voiced concerns regarding the incentive structures of some longer-dated vehicles, yet they are willing to tolerate high fees provided returns remain strong.

Creating an ESG portfolio 

The growing interest in environmental, social, and governance (ESG) principles is driving noticeable behavioural change across private equity, particularly in Europe. This asset class is in a formidable position to apply such policies to its investments, as it aligns with the longer-term perspective synonymous with private equity. Clients are taking a keen interest in ESG, with some LPs regularly benchmarking their General Partners' portfolio companies against benchmarks like the UN's Sustainable Development Goals.

Investors are direct

Any misalignment of GP-LP interests could have consequences other than clients simply repositioning or consolidating private equity mandates. It could lead to greater adoption of direct investing by sophisticated institutions. A SuperReturn attendee confirmed that the number of GPs in its portfolio had been reduced by 75 percent in favour of co-investing and direct investing approaches. 

As direct investing is not impacted by fee leakage, the gross returns are attractive, particularly to pension schemes that may be facing funding deficits. Direct investing, however, does require particular resources and experience. Despite the potential risk of disintermediation, some GPs are bridging the knowledge gap by inviting clients to internal investment meetings for educational purposes. 

Acclimatizing to regulatory change and disruption 

The regulatory calendar remains active. While many regulations are being managed in a 'business as usual' manner, such as the European Union's (EU) Alternative Investment Fund Managers Directive (AIFMD), and the Foreign Account Tax Compliance Act (FATCA), the private equity industry is cognizant that further change is on the horizon, largely as the result of the UK's impending withdrawal from the EU in March 2019. 

Holz identified disruptors in the payments industry and capital markets sector as being among the most promising revenue sources in the sector

For UK-based private equity managers running AIFs, Brexit decisions loom. AIFs may choose to shore up EU operations and retain the right to passport to EU clients, or remain in the UK, which could compromise their existing and relatively unconstrained distribution across the EU.  

Giving the ongoing uncertainty about the UK government's position on Brexit, more than 18 months after the referendum result, some firms are hoping for a transitional arrangement to be negotiated between the UK and EU, which would provide more time and flexibility to finalize contingency plans. 

Managers closing funds in and around 2019 may find it harder to raise capital, at least from European LPs, and some firms report prospective clients are less inclined to allocate capital to GPs with large UK portfolio holdings. However, one mid-cap manager told SuperReturn that he was pleasantly surprised by the UK economy's resilience to Brexit, although he conceded that currency volatility has forced organizations to reassess their hedging strategies. 

Anticipating AIFMD II 

The assumption that private equity can simply fall back on national private placement regimes (NPPRs) or reverse solicitation post-Brexit to access EU markets is not set in stone, said a regulatory expert. AIFMD is up for review by the European Commission (EC) without UK input, with a market study expected in 2018, and the expert warned that NPPRs and reverse solicitation, both of which are quite restrictive, could become obsolete, much to the disadvantage of third-country managers. 

Equally, delegation is not secure, which could undermine existing distribution arrangements for third-country managers. Third-country managers using delegation have already been forewarned by the European Securities and Markets Authority against using letterbox entities. Local regulators, including the CSSF in Luxembourg, are also probing delegation arrangements more actively ahead of the anticipated crackdown. 

At present, private equity firms are identifying short-term fixes to remedy Brexit's disruption to fundraising and marketing, but these solutions will only work if AIFMD is not dramatically altered moving forward. “There is a very real possibility that the regulatory regime is going to become much harder for managers outside of the EU," commented the regulatory expert.