Sunrise, sunset or sunrise redux for private equity?

Expectations for private equity’s future were at best foggy in the wake of the global financial crisis. The broader consensus post 2008 was that the industry was poised for significant contraction.

The thinking was that those with mediocre returns and short track records would become victims of an industry-wide reshuffle. Those that survived would have to get used to a diet of smaller deals and lower returns.

For a while, it seemed as though that assessment was wrong, as private equity, like its hedge fund sister, appeared to be regaining favor among investors searching for non-correlated returns.

However, a recent report by second-hand private equity investment firm Coller Capital suggests the bigger picture isn’t as sunny as the short-term rebound might indicate.

Indeed, according to the report (click here to download), one in five private equity groups will up and disappear during this decade, a shakeout that despite two-plus years beyond the financial crisis has yet to occur.

Almost nine in 10 investors expect to turn down some of the requests by private equity groups to reinvest into their next fund generation, according to the survey of 110 investors (see chart below outlining deterring factors against reinvesting).

What the report underscores is how large investors including pension funds, fund of funds and insurers have started to become much pickier in the wake of the financial crisis, and that underperformers have become more visible.

In the “golden age” of 2002-2007, the prevailing investment methodology to private equity wasn’t that different from buying blue-chip stocks – you bought, held and sold for a double-digit return, plain and simple. Investors poured record amounts into the industry, while bankers did their bit by relaxing standards on credit.

In the wake of the financial crisis and the bust of the credit bubble, however, investors quickly realized that not all private equity funds and managers were created equal, and that transparency, valuation methodologies and, to a very significant extent, the amount of leverage used could have a very negative impact.

The ongoing problem since the crisis has been how to exit current investments with capital – never mind returns – intact, providing cash distributions to investors. More recently, though, the tougher trend among private equity funds has been how to make new investments and how to convince investors to continue along for the ride.

Indeed, according to Coller, reinvestment is one of the main issues facing the industry. The vast majority of investors surveyed named poor performance of a private equity fund as the main reason not to reinvest, with succession issues being mentioned as the second most important argument. The chart below shows the expected proportion of GPs that will not be able to raise a new fund in seven years.

To be sure, it’s not all bad news. While some of the sector’s worst performers are set to disappear, investors have gained more confidence in the asset class as a whole. More than a quarter of those surveyed said they intend to increase their target for investments into private equity, while only 12% indicated they wanted to reduce it.

That ratio has been steadily improving since the height of the credit crisis in the summer of 2009, when for the first time there was a higher proportion of investors wanting to shrink their allocation to private equity.

A record number of investors said they were looking to reshape their portfolios by selling second-hand private equity assets. More than a third of U.S. investors, a quarter in Europe and 42% in Asia, plan to depose their second-hand private equity holdings over the next two years, according to the survey results.

And the private equity industry has faced what has been described as its sunset before. In 1990, when Drexel Burnham Lambert collapsed, the private equity business literally lost almost all its financing overnight. Managers focused on smaller deals and weaned themselves off debt.

The question is whether a similar scenario will play out again, and whether investors disgruntled by the past few years of performance but still on the search for decent yield will give it another go.

Sunrise, sunset or sunrise again?

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