What the Dickens Do Investors Want?

By Christopher Faille

SEI (NASDAQ:SEIC), the international investment management and outsourcing company, says that investors, institutional investors in particular, have great expectations for the private equity market.  Whether one is speaking of the money of familiar sources like Miss Havisham or that of more mysterious sources like exiles Down Under, investment capital is in search of the right recipient.

What does one need to do to be the “Pip” in this analogy?

SEI conducted a Private Equity Survey of managers, investors, and consultants working in PE, and plans to release the results of this survey over the course of three papers. It has just posted the first of these, on the Logic of Fund Flows – a look at asset allocation trends among investors, with a focus on how they evaluate and select their managers.

Forthcoming papers shall discuss the search for an alignment of interests between managers and investors, and finally the changes managers are making along with the challenges they continue to face in the competition to attract capital.

Stretching for Higher Fruit

The top line, the premise of this survey, is that the private equity business is on the road to recovery. Movement along this road may be measured by fund inflows (which are picking up) and by successful exists from portfolio companies (there has been a surge thereof.)

On the exits: the second quarter 2011 saw more than 300 exits with an aggregate value of $120.1 billion, which as SEI notes – drawing on figures from Preqin Quarterly, Q2 2011 – easily eclipsed “the previous record of $81.5 billion set in the fourth quarter of 2010.”

Successful exits remain a concern though. Indeed, the SEIU paper calls the recently achieved exits the “low-hanging fruit.” That fruit already eaten, the creatures of the PE forest will have to work better to get up to the higher branches.

A related point is that the post 2008 crisis will not leave the industry unchanged. It has permanently altered the dynamic between investors and fund managers by persuading the former that the latter owe them more transparency and better liquidity terms than they had been accustomed to receive, and that fees have to come down. Pip has to learn how to be a proper gentleman.

The survey begins at the beginning. Why do investors decide to invest in PE at all? What is their chief objective?  Roughly two-thirds of the institutional investors questioned said that they were after the return potential. Diversification was a poor second place. This isn’t how consultants see things, though. Half of the industry consultants surveyed said they thought diversification was the most important reason for investing in PE. The second-place answer among consultants was itself a close kin to diversification: non-correlated investment returns. Return potential came in third.

Good News and Bad News

A measure of both the opportunity and the challenge facing fund managers comes when investors are asked whether they “plan to increase or decrease [their] allocation to private equity in the next 12 months?” The good news is that only a sliver on a pie chart, 1.8 percent, indicates that it plans decreases. The bad news, though, is that only 25.5 percent of those asked say that they will increase allocation. The remainder, a whopping 72.7 percent, plans no change.

The institutions most likely to raise their allocations are foundations and endowment, and the increases are likely to be modest, i.e. in the 1 to 5 percent range.

There is always, of course, the question of fees. “A preoccupation with fees suggests growing dissatisfaction with manager performance, as fee pressure tends to mount when investors do not see value being demonstrated by their managers,” the SEI notes.

The importance of fees was rated a little above 3, on a scale of 4, in the survey of PE investors. By contrast, in a separate survey, hedge fund investors rated fees as of only “middling importance,” so this may suggest “greater satisfaction” among hedge fund investors than exists among PE investors.

The bottom line, though, is a lot like the top line: institutional investors have great expectations for private equity, and the right fund managers, willing to meet their “increasingly exacting standards,” will be in a position to  listen to “capture part of the  growing flow of assets” in that direction.

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