Keep a close eye

Recent figures from the European Venture Capital Association have shown pension funds have overtaken banks as the main source of the European private equity industry for the first time since 2001, contributing 25pc of the €72bn (£48.5bn) raised in 2005, compared with 18pc from banks.

Fifteen years ago private equity was a non-event. Most institutions, at least in Europe, were not investing in what was considered a very “risky space”. Contributors to this asset class were North American pension funds and a few high net worth families around the globe.

In the late 1990s, European investors – and regulators – started to look positively at this new asset class. The reason why was simple: private equity was enjoying impressive returns. Nowadays, almost every financial institution holds private equity directly or indirectly.

“Pension funds need returns” is no news to pension holders or to the people who manage them; what is news is that for the first time in recent economic history the phrase has gained more weight in trustee boardrooms than the phrase “Pension funds need to avoid risk”.

Private equity has done a lot to bring about this change of attitude by demonstrating that risk is good when it is the very basis for an investment thesis and when the asset to which the risk is attached is actively managed. This virtuous circle leads to lower volatility of returns for private equity when compared to equities. Not bad for a “risky space”.

With private equity expected to return 9.6pc, while equities stall at around 7.5pc, this new found attitude embracing private equity is going to be reinforced. We will see more private equity in traditional institutional portfolios, with rates of return built into plans and pension funds increasingly cutting their exposure to equities in order to reduce the volatility of their portfolio.

However, many consultants (especially those with large equities practices) who advise pension funds increasingly share the opinion that the perceived low overall portfolio risk of private equity is simply too good to be true. This might explain the inertia towards increasing private equity allocations in certain institutional circles. Too good to be true? This is a question worth asking and the answer lifts the cover on some uncomfortable recent trends in private equity.

One of the reasons why pension funds have increased their appetite for private equity is the relatively high investment returns generated recently by leveraged buyouts (LBOs), especially in the large-deal segment. This is in part due to a very favourable debt financing market and the current rally in the merger and acquisition market, but also because private equity funds are selling and buying among themselves.

Serial LBOs like these will become more commonplace, as will mega-deals – deals over €10bn (£6.7bn) – because of the scale of funds being raised. To underline this, it is enough to remark that 2006 was already a record fundraising year halfway through. As LBOs get bigger and their dependence on debt markets and on the health of the M&A market increases, however, it will become more difficult to respect the fundamental tenet that private equity is not correlated with traditional asset classes. The ability of LBO firms to rapidly resyndicate mammoth acquisition debt will only last as long as the ability of the market to absorb it. On the lower end of the spectrum, small is still beautiful, as reasonably-sized buyouts have so far brought return with limited risk.

As of December 31, 2005, private equity represented over $1.3trn (£666bn) – i.e. almost 100 times more than it did 15 years ago. Does this mean that there is too much money in the asset class? The right question to ask seems to be whether there are too many “me-too” funds in the asset class, or too many auctions.

Private equity players have to be careful to make sure that growing popularity does not lead to disappointment if there are not enough relevant investment opportunities for the wall of money available.

Traditionally, private equity was a “buy and hold” asset class. Funds were established for 10 years (or more), and, even though money was called when necessary and returned to investors when used, investors could not get out easily before the term, and without leaving a lot of money. This is no longer the case.

Indeed, given private equity funds’ increased popularity, managers want to put more money at work more quickly. One efficient way to do this is to buy on the secondary market. This has created many new buyers and has had a positive effect on prices. Investors can now get out of funds early, and, in some cases, can enjoy a premium on net asset value. Knowing there is a fair way out, and the capacity exists to manage the portfolio, renders the asset class even more attractive for pension funds.

Private equity has become a widely accepted and utilised asset class. But enjoying its benefits is not without difficulties for investors. With acceptance comes popularity, and LPs should be wary of a surge in the number of available funds but a drop in the number of available deals.

As is already quite standard in all other areas of finance, investors should keep an eye on their portfolio and prune or add to it by taking advantage of the secondary market. Looking in the rear-view mirror can only tell you where you came from, not where you are going. Pension funds should remember that past performance is no guarantee for future results and the future will bring its own crop of star firms and great private equity investment opportunities.

Antoine Dréan is the founder and managing director of Triago