Private Equity International’s (PEI) annual survey of limited partner (LP) sentiment, published Dec. 6, has highlighted a number of factors influencing allocators’ attitudes toward private equity as an asset class heading into 2020.
As I discussed previously in “Private Equity 2020: Allocators Show Mixed Outlook,” chief among these factors are fee-related conflict, late-cycle style drift and increasing recession risk, which have all served to curb allocators’ enthusiasm for private equity to one degree or another.
But that is not the entire story. Indeed, there are other looming issues causing increasing anxiety for allocators and private equity firms alike.
Losing confidence in excess return potential
Private equity offers two key value propositions to investors: exposure to diversified, private assets with limited correlation to publicly traded assets and access to market-beating returns. The extent of private equity’s diversification benefit is beyond the scope of this discussion, but the question of returns is not.
Private equity funds promise investors risk-adjusted returns in excess of other asset classes (especially stocks). However, PEI’s latest survey of allocators suggests they are losing confidence in private equity funds’ ability to deliver the outperformance they promise:
“While the headline numbers look strong, investor confidence in the asset class has actually dipped slightly from last year: 23 percent of LP respondents expect their private equity portfolio to exceed its benchmark in the next 12 months, compared with 41.5 percent last year, while 11 percent expect it to fall below, compared with 8.5 percent last year.”
This can be seen as the natural result of demand saturation. With unprecedented allocation levels to the asset class persisting for years, a glut of dry powder has made it increasingly challenging to find worthwhile deals, as prices are bid up and competition intensifies over a finite number of top-tier opportunities. At the same time, popular benchmarks, such as stock market indexes, have outperformed their historic trends, further hampering private equity’s ability to shine. In a sense, the private equity industry has become a victim of its own success.
Legislative risk looms
Senator Elizabeth Warren of Massachusetts, who is also among the top tier of candidates for the Democratic Party’s 2020 presidential nomination, shook the private equity industry to its core in July when she introduced the Stop Wall Street Looting Act. Warren’s bill would place substantial restrictions on the industry in an effort to prevent a number of politically unpopular activities, such as asset-stripping, with which the private equity industry has become heavily associated.
PEI has offered regular coverage of Warren’s bill since it was introduced, as well as analysis of its potential impacts on both the industry and the broader economy. In its survey of limited partners, PEI found that some allocators actually favor some components of Warren’s bill, though there is fairly universal opposition to its most intrusive provisions:
“Respondents were most in favor of prohibiting deals for LPs that are not offered to all investors and eliminating monitoring fees. At the other end of the spectrum, investors were most against stopping tax deductibility of interest payments and, unsurprisingly, the provision forcing GPs to publicly identify investors.”
It is hardly surprising that allocators find Warren’s provisions calling for equal treatment of investors and a restriction of certain fees rather appealing. Likewise, their antipathy to losing tax benefits and their access to partial anonymity is also understandable.
Of course, Warren’s bill may never become law, even if she is elected president. Still, a Warren presidency would likely result in very real political and legislative threats to the private equity industry as it is currently constituted. Even in defeat, she might manage to persuade enough Democrats in Congress to her way of thinking. Understandably, these prospects have allocators worried.
Verdict
Private equity remains a very popular alternative asset class and allocators show no sign of diminishing their exposure. I do not expect a major retrenchment away from private equity to occur in 2020. Few industry analysts and commentators do. However, the risks associated with the asset class have been growing even as its return profile has shrunk in aggregate.
Allocating to a private fund under currently prevailing conditions does not seem prudent. Investors seeking exposure to private equity might be better served by taking positions in publicly traded (i.e. more liquid) private equity firms like KKR & Co. Inc. (KKR, Financial) or Blackstone Group Inc. (BX, Financial).
Allocators’ concerns about the industry’s future have been magnified over the past couple years. As 2020 looms, with all its political, economic and market risks, investors may begin to blanch at their allocations to illiquid vehicles whose risk-adjusted returns have failed to sizzle quite as promised.
Disclosure: No positions.
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