Altius highlights Key Challenges Facing Private Markets in 2015

LONDON, UK (January 21, 2015) -- According to Altius Associates’ (“Altius”) annual review: ‘Key Challenges Facing Private Markets in 2015’, one of the biggest challenges facing Limited Partners (LPs) in 2015 will be maintaining investment discipline while re-deploying record levels of private equity distributions over the past two years.

In the US, the report identifies one of the main challenges as determining which General Partners (GPs) will be able to generate attractive returns in today’s high purchase price environment.  Turning to Asia, Altius questions how the private equity industry will continue to grow as the region enters a “New Normal”, a pan-regional landscape characterised by lower growth and political leadership changes.  In Europe, the report focuses on the challenge of identifying alpha-generating opportunities in a low growth environment.

In the booming secondary market, Altius questions how the growing use of leverage will affect the industry.  The report questions whether this represents savvy deal-making by secondary buyers and a natural evolution of the industry or simply driving up prices and increasing portfolio risk.

While private credit strategies have seen a major increase in interest from institutional investors, Altius believes the biggest concern for 2015 is whether or not GPs can expect to continue receiving the substantial return premium over liquid credit markets that has characterised the sector in recent years.

The report also examines the challenge of how private energy investors should respond to the dramatic fall in oil prices.  Altius believes that smart investors will take advantage of today’s environment and invest with quality managers.  Conversely, those who decide to wait until things settle down will miss out on a classic opportunity to buy low and sell high.

Altius provides more detail below on each of the challenges:

According to Altius, LPs must overcome many obstacles in order to maintain investment discipline.  While strong distributions and positive public markets are both good conditions for institutional investors, together they can very quickly place a private equity portfolio into an under-allocated position.  This can increase the pressure to re-invest or deploy capital at a higher rate to make up for lost allocation.

Altius believes that pressure to invest can emanate from a number of areas including: GPs returning to market quickly and in rapid succession; LPs placing more capital with fewer GPs; and new LP entrants with scale exacerbating the scarcity of supply in funds managed by premier GPs.  Very few LPs have reduced their allocation to private equity, and in fact several recent surveys indicate an increasing number of LPs are planning to raise their allocations.

Brad Young, Co-CEO, Head of Investments at Altius, said: “Throughout different cycles, the pressure to invest has always manifested itself in a key way: the backing of marginal GPs.  The venture capital bubble of the late 1990s captured this tendency as LPs felt that investing with lower rated managers would still outperform the benchmark; investors sometimes forget that investing with a second quartile manager does not always result in a positive return.  The “pressure to invest” phenomenon also showed itself when LPs aggressively invested in mid-market buyout funds with little or no track record, under the rationalisation that the addition of a new manager would be beneficial to the private equity  portfolio.  To further complicate this matter, a poor fund investment choice in the private equity space can take three to five years to truly come to light.

“Successful, long-standing LPs have realised that not making an investment is an investment decision. A drop in the quality of an investment may cause longer term problems in a portfolio, and manager proliferation can lead to underperformance.

“Patience and discipline are always welcome characteristics in asset allocation and portfolio management; the current private equity environment, with strong distributions and high valuations, warrants careful attention to avoid some of the mistakes that LPs have made in past market cycles.”

Currently, the main challenge investing in Europe is how to achieve attractive returns in an environment where prices are high and leverage is plentiful, but growth is not.  Manager selection has always been of paramount importance to the success of private equity programmes and it is even more critical in today’s low growth environment.  In Europe, secondary deals now account for over half of all deals (in some countries such as France it is even higher), and GPs consistently report that high quality businesses are not cheap.  These factors, combined with the availability of ample debt, mean that intermediated deals are expensive.

On the positive side, as in the US, it is a great environment for GPs to achieve exits at attractive prices – a boost for LP returns.  But LPs should remember the lessons of the past; this market dynamic cannot continue indefinitely.  Prudent managers need to ensure that they are not overpaying for acquisitions today, and they should plan for a market in which exits are not so easily achieved and multiple-arbitrage is less prevalent.

Rhonda Ryan, Partner and Head of EMEA Investments at Altius commented: “Given the current environment LPs must look for alpha-generating opportunities.  It is important to make sure that companies have a customer base that is diversified away from low growth Europe and towards growing economies such as Asia and Latin America.  Companies should have a strong market position and be defensible.

“Investors must be selective, and this is true for both GPs and LPs.  Competition will continue.  Prices are higher, debt is plentiful, and dry powder is high and increasing.  LPs must focus on the best managers and avoid the temptation to step down in quality.  One crucial element is to identify GPs that have a different sourcing angle and know how to add value – there are still plenty of good opportunities available across Europe.  Most importantly, LPs should continue investing in Europe as history has shown that investors shouldn’t try to market time.  LPs need to allocate consistently across the cycle to produce the best long term return.”

According to Altius, the impact of falling oil prices will clearly have an impact on US private energy investing, but it will be felt differently across sub-sectors and geographies.  While the power sector will remain largely unaffected and the midstream sector will see modest effects, oil-dominated upstream assets are directly and negatively impacted, and existing investments will be marked down in value.  Planned near-term exits will likely be delayed.

Natural gas assets in the upstream subsector may benefit from declining oil prices.  This is a result of a reduction in the amount of associated (i.e. incidental) gas production from wells where the primary target is oil.  Oilfield equipment & services is the most heavily impacted subsector.  Cutbacks or slowdowns in drilling and production programmes affect this subsector first and most severely.  Private energy fund managers must ensure that their portfolio companies take quick action to cut expenses and conserve resources.  Distress in the industry will provide great deal flow to those who have the capital to deploy.   The highest cost shale oil basins will be impacted greatly by falling oil prices, while activity in low-cost oil and natural gas-dominated basins will continue as before.

Jay Yoder, Partner and Head of Real Assets at Altius commented: “Our advice to LPs is to spend very little time trying to discern where oil prices are headed.  Even those who have spent their careers immersed in the energy industry cannot make accurate predictions on energy prices.  Second, invest only with quality managers.  The best upstream GPs do not get carried away by bullish views on commodity prices.  Third, take advantage of the current market environment and make significant new commitments to quality private energy funds in the upstream and equipment & services subsectors.  These are positioned to generate outsized returns in the years ahead.

“Volatility in the energy markets is nothing new.  Cycles, even severe ones, come with the territory.  Smart investors will take advantage of today’s environment and invest with quality private energy managers while others wring their hands and decide to wait until things settle down—thus missing out on a classic opportunity to buy low and sell high.”

One of the main challenges when investing in U.S. private equity today is determining which GPs will be able to generate attractive returns in the current high-purchase price environment.  LPs need to look at myriad characteristics of GPs to assess which managers are best positioned to deliver outsized returns going forward.

Dr. William Charlton, Partner and Head of U.S. Investments at Altius, commented: “It’s no secret that purchase price multiples have returned to, and in some segments exceeded, the peak levels of 2007.  This is primarily due to the increased number of private equity firms competing for a limited number of high quality deals, the increasing efficiency of a more intermediated market, the high level of dry powder, and the current favorable access to ample debt.  One positive aspect of high multiples is that GPs are able to exit portfolio companies at attractive valuations, often with a fair amount of multiple-arbitrage helping to amplify the returns; however, GPs and their LPs cannot expect this situation to continue indefinitely.  Prudent GPs should plan for some degree of multiple contraction in the exit planning of companies purchased at today’s high multiples.

“The opportunity still remains for GPs to pay fair multiples for companies, especially at the less intermediated, smaller end of the market.  GPs with a certain “edge,” such as experience with a similar company, a well-developed relationship with management or sector expertise may also be able to “win” deals on factors other than just price.  For those GPs without obvious purchasing advantages, there is still an opportunity to generate acceptable private equity returns in a high priced environment; however, GPs must be sure that their investment thesis is solid, as the higher prices leave little room for mistakes or delays in hitting milestones.  Private equity firms that have a superior ability to source companies, a good investment thesis, and the operating resources and expertise to grow those companies will still be able to outperform even in this environment.”

Catherine Mountjoy, Partner at Altius, added: “Some LPs may choose to “sit out” the private equity market under the assumption that the current vintage years are unlikely to generate commensurate risk-adjusted returns.  We view this as potentially short-sighted in light of the long-term nature of private equity investment programmes.  Maintaining a steady exposure to private equity by selecting top quality GPs helps to ensure that LPs have capital committed to funds that have the ability to generate returns in any market environment.  Accurately predicting a market turning point is difficult, and capital deployment in private equity is almost always challenging.  Maintaining commitments to quality managers can position LPs to capture value on the buy-side when the pricing environment returns to more favorable levels.”

According to Altius, the secondary market continues to mature and evolve at a rapid pace as buyers are continually looking at innovative structures and new sources and types of deals outside the traditional purchase of fund interests.

One contributor to the growth in volume and strong pricing over the past few years is the increasing use of leverage.  Leverage is not new to the secondary market, but it is certainly fair to say that its use has become more prevalent over the past few years as a way to enhance returns.

Chason Beggerow, Partner at Altius commented: “Proponents of leverage in the secondary market will argue that some of the larger portfolio secondary transactions are highly diversified and are well suited to it.  From what Altius has seen to date, the use of leverage by secondary buyers has largely been conservative but this has occurred during a period of industry tailwinds.  The secondary market has yet to endure a down market with an increased use of leverage.

“As 2015 unfolds, LPs interested in the secondary market (both by investing in secondary funds as well as accessing the secondary market directly) should keep an eye on the amount of leverage in the secondary industry.

“Ultimately, the question remains as to whether the increased use of leverage in the secondary market is savvy deal making by secondary buyers and a natural evolution of the industry, or a mechanism for driving up prices and adding risk to secondary portfolios.  This is an area that Altius will be monitoring closely in 2015.”

Private credit strategies (direct lending, mezzanine, distressed debt, special situations and venture debt) have seen a major increase in interest from institutional investors seeking viable alternatives to bolster their fixed income portfolio yields or increase the diversification of their private markets portfolios.

Increased LP interest in private credit strategies has been reflected in the fundraising figures for credit funds managed by private GPs, especially direct lending funds.  In the wake of bank deleveraging, large globally active GPs from both private equity and fixed income have increased their activity in the direct lending market to benefit from the increasing level of return opportunities.

Elvire Perrin, Executive Director and Partner at Altius commented: “With the decrease in direct lending activity by banks and the corresponding increase in the amount of capital being raised for private direct lending strategies, the question going forward for market participants is whether or not GPs will be able to maintain the substantial return premium over liquid credit markets, estimated to be on average between 300 and 400 basis points per annum over the past few years.  Additionally, many GPs are signalling that banks are becoming more active in lending to buyout deals over a certain transaction size and where the debt is rated above B+ (based on the S&P classification).

“We believe that the private direct lending premium will remain high enough for investors to continue deploying capital to this attractive strategy, even though the increase in fundraising will put some pressure on pricing and the available private market premium.   Differentiated strategies, such as direct lending to non-sponsored deals and growth companies, should remain attractive niche spaces that are capable of providing higher expected returns than typical direct lending strategies.  Finally, a focus on the small and lower-mid corporate space will be essential in maximizing the pricing/return premium.”

In 2014, Asia entered a “New Normal” – the changing characteristics in the Asian macroeconomic and political landscapes that are expected to persist for a period of time.  Asia is witnessing lower growth in both developing and developed markets; many larger countries in the region have gone through leadership transitions, with new leaders keen to enact concrete pro-business policies backed by a strong political mandate; and Asia is experiencing diverging valuation dynamics, with select markets above and others below historical averages.

The impact of these changes on future private equity returns is a key question on investors’ minds.  As all of these changes take place within the landscape of Asia, institutional investors are questioning if now is a good time to invest in Asia and if expected returns justify private equity investments in the region.

GDP growth has traditionally been cited as a strong supporting case for Asian private equity but several studies paint a different picture and suggest that private equity is ultimately a micro-business.  With slower growth forecast for the region, there is a clear emerging trend for an increase in control deals in Emerging Asia, which has traditionally been a growth equity market.

Peter Pfister, Partner and Head of Asia-Pacific Investments at Altius commented:  “Deal valuations continue to remain attractive for Asia.  Although valuation cycles differ from market to market, as a whole the dynamics benefit the asset class in the region.  Fund managers are continuing to close the valuation gap between buyers and sellers by building strong operational teams that have deep industry knowledge and networks to add even greater value to portfolio companies.

“Exits have also been an important element for Asia-focused fund managers.  GPs are increasingly adopting highly versatile exit mechanisms, including trade sales and M&A.  We expect this momentum to carry on in 2015.

“The “New Normal”, with slower growth and new leadership in a large subset of Asian economies, is expected to positively impact consolidation and maturation of the Asian private equity industry.  These unfolding dynamics are pushing market players to develop clearer differentiation in origination, robust operational value-add capabilities, exit strategies and building a long-term sustainable platform.  More importantly, the private equity cycle is showing healthy signs of sustainable growth in the future, with record exits in 2014, increased investment activity, and less overall competition.   This will very likely support an increased interest in the region by global investors, particularly considering the relatively modest valuations as compared to the U.S. and European markets.  These developments bode well for the future of private equity in the region and will become the bedrock of stronger and more stable returns.”