The Future of Private Equity: New Opportunities, New Challenges

Feb 3 2017 | 7:41pm ET

Editor’s note: The private equity industry’s astonishing rebound since the financial crisis has been nothing short of spectacular, writes the team at SEI in this contributed article, but it has also evolved – and is evolving – at a furious pace. Stakeholders must contend with, and properly plan for, a wide array of trends, challenges and opportunities facing the industry, ranging from a fluid regulatory environment to a proliferation of strategies and investment options available.

The Future of Private Equity: New Opportunities, New Challenges

It has not even been a decade since the private equity industry was on the ropes. Liquidity dried up while deal flow and fundraising collapsed in the shadow of the devastating financial crisis and the viability of many fund managers was thrown into question. Since then, the global private equity market rebounded dramatically, growing at an unprecedented rate. It is also evolving quickly, perhaps more so than any other sector of the asset management industry. What is it likely to look like in the future?

Winston Churchill once cautioned that “It is always wise to look ahead, but difficult to look further than you can see.” Our analysis is not designed as a crystal ball to speculate on the shape of private equity in the distant future. Instead, we hope this research will illuminate current trends and provide concrete intelligence that helps investors and fund managers better navigate this quickly changing environment. A clear view of where the industry is heading can benefit all stakeholders, informing investment strategies, assisting in due diligence, instructing negotiations, redefining operating models, establishing options and setting a strategic course as new challenges emerge alongside tantalizing new opportunities.

The Key Findings:

In an effort to better understand where private equity is heading, SEI surveyed more than 200 industry participants. This year’s survey builds on earlier analyses of the private equity industry dating back to 2009. Participants include general partners (GPs), limited partners (LPs) and consultants.  The key findings include:

Growth Opportunities

  • Industry assets are projected by survey participants to grow at a median annual rate of 5.8% over the next decade.
  • GPs expect more fundraising opportunities among a wide range of institutional investors.
  • Sixty-four percent of LPs plan to increase their allocation to private equity, marking a steady gain from only 26% five years ago.
  • GPs predict wealthy individuals will generate considerable demand for private equity going forward, either directly or through family offices.
  • Four out of every 10 participants plan to buy or sell secondaries over the coming year.
  • One out of every five LPs now prefers coinvestments over traditional closed-end funds.
  • Private debt is becoming a cornerstone of many private equity firms’ growth strategies.

Operating Challenges

  • Compliance is one of the most pressing operational challenges. More than eight out of 10 GPs say compliance costs are climbing faster than other operating expenses.
  • GPs are facing greater scrutiny from LPs as well as regulators. Two out of three LPs say they are increasing the level of operational due diligence they perform when hiring a new manager.
  • Data management has also proven to be a vexing challenge for many firms. One out of three LPs now expect GPs to provide for data mapping into their portfolio monitoring systems.
  • Fee pressure and transparency demands from large institutional investors are pressuring the bottom line at many funds.

Selection Process

  • The emphasis placed on investment performance continues to grow, with LPs and consultants more likely to view it as a “very important” factor than any other selection criteria.
  • The reputations and credentials of fund managers still play important roles in the assessment process, but they are not as paramount as they used to be. 
  • There are pronounced gaps between LPs and GPs on the importance of portfolio transparency, fees and reporting as it relates to selecting fund managers.
  • Consultants are more likely than LPs to emphasize risk management infrastructure, a separation of investment and operations, and the presence of an independent administrator when evaluating fund managers.

Business Models

  • A specialized business model is widely viewed as more competitive than a diversified approach, but consultants are more apt than GPs to tout the virtues of a diversified model.
  • Compared to other asset managers, private equity firms continue to perform many more functions in house.
  • Outsourcing can enhance the ability of GPs to manage data, monitor complex investment strategies, handle customized portfolios and improve investor reporting.

MAINSTREAMING MEANS MORE GROWTH

Private equity went from a niche asset class two decades ago to one that is much more likely to be found in individual and institutional portfolios today. Since 1995, assets have risen dramatically, growing from $30 billion to approximately $4 trillion 20 years later. This represents a compounded annual growth rate of almost 28%, or an astonishing 133x rise in total assets. In contrast, long-term mutual funds in the U.S. grew 10% annually over the same period, with assets growing sevenfold.

It is unlikely that the industry will maintain this torrid rate of growth forever, but many survey participants are convinced that strong demand will continue to drive asset growth at a healthy clip over the coming decade. Some survey respondents predict that assets will grow to as much as $20 trillion 10 years from now, but most take a more conservative view, with a median projection of $7 trillion implying an annual growth rate of 5.8%.

With such growth prospects, even skeptics may want to acknowledge the fact that private equity is well on its way to becoming a mainstream asset class. What was once the purview of university endowments and wealthy individuals is now considered a core holding by many types of institutional investors. And with this growing universe of investors making larger average allocations to private equity, capacity constraints may ultimately slow growth before demand ever does. Even retail investors are getting involved through the growing number of vehicles that provide private equity exposure at low asset thresholds and more liquid terms.

STRATEGIES AND VEHICLES PROLIFERATE

One of the main drivers of growth in the private equity market is the expanding palette of investment options available to investors. Managers are diversifying the types of strategies offered, and investors are expressing interest in products to which they previously had little or no access.

Meanwhile, both are making use of a wider range of investment vehicles. Traditional fund structures (co-investment, direct investment and separate accounts) will continue to dominate. However, those structures will increasingly be joined by more liquid options catering to investors wanting private equity exposure but reluctant to commit to multiyear lockups. The booming secondaries market is testament to this trend. Drawn by strong performance and accelerated cash flows, approximately four out of every 10 investors and fund managers in the survey plan to participate in the secondaries market during the coming year. 

Contrast this to 2009 when we first examined the secondary market, only 30% of LPs said they bought or sold secondary investments. GPs are more likely to engage directly with buyers and sellers of secondary assets while LPs are most likely to invest through a secondaries fund. Exchanges and platforms are still less common, but their use is growing.

The term “private equity” itself is becoming a misnomer, as direct lending vehicles take market share from banks, making private debt a cornerstone of many private equity firms’ growth strategies. Interest in private debt has exploded in recent years and can now be found in more than half of all institutional portfolios. Investors have been drawn to private debt as an asset class for a variety of reasons, including competitive returns and diversification benefits provided by an asset class that has historically exhibited low correlations to other types of investments. 

Private debt comes in several flavors, and there doesn’t appear to be a current consensus on which of these is likely to prove the most attractive over the coming year. GPs and consultants indicated that special situations debt is particularly appealing. LPs are more likely to be drawn to distressed debt. Direct lending strategies are also receiving considerable attention, as nonbank lenders continue to proliferate, servicing more niches and increasingly securitizing their lending portfolios.

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