Pavilion Alternatives Group™ Highlights Seven Key Challenges Facing Private Markets in 2017
25 January 2017 – London, Singapore, Sacramento – 2016 produced another strong year of returns but there are a number of challenges facing investors in 2017. One of the biggest facing limited partners (LPs) will be drawing a distinction between private equity fund managers that are genuine value creators versus market beneficiaries. Investors will face the complex task of selecting which general partners (GPs) to back in what is likely to be a more challenging investment environment. According to Pavilion Alternatives Group™ (Pavilion), this, together with weighing the risks and opportunities of investing in GPs raising larger funds, and dynamic political environments represent some of the concerns identified in its annual review: ‘Key Challenges Facing Private Markets in 2017’.
Commenting on the outlook for the private equity market in 2017, Donn Cox, President & Managing Director of Pavilion Alternatives Group™, said: “The challenges for 2017 are those relating to the sector’s ongoing success. Our biggest concern for the year ahead is the continued increase in valuations as capital has flowed into the private equity sector. At some point, the economy will slow, and it will be interesting to see if certain investments can meet their return expectations. We attempt to manage this by advising clients to invest steadily across vintage years to ensure balanced exposure over time.”
Determining whether the manager or the market made the difference
While the last few years have been the best exit years in the history of private equity markets leading to record levels of distributions, there remains a problem for LPs: the reinvestment decision. How much of the attractive returns can be attributed to the market and how much to the manager? According to Pavilion, making the distinction between market beneficiaries vs. value creators requires extensive experience in the various private equity markets as well as deep knowledge of the individual fund managers including their team dynamics, their strategy and their value creation capabilities.
Positives and negatives to larger fund sizes
Private equity investors increasingly face the decision of whether to continue to back a successful GP that is raising a larger fund than their previous fund. Larger fund sizes can be a double-edged sword for LPs. While investors often rely on larger fund sizes to gain access, there are concerns about how more capital can impact the firm and strategy, potentially diluting those characteristics that made it successful in the past. Pavilion advises that assessing the impacts of a larger fund size, such as strategic consistency, investment process, investment size and post-investment execution should be part of any due diligence process in order to understand the merits and potential risks.
Brexit and investing in the UK
In assessing the impact of Brexit on the private equity market in the UK, Pavilion contends that even if there is some decline in activity at certain points in time, it is hard to envisage the UK moving from being the biggest force in European private equity to a minor player. For LPs looking to have exposure to European private equity, it remains important to continue to invest in the best GPs in the UK and to remember that private equity as an asset class tends to outperform in periods of uncertainty as buying opportunities may emerge.
Solving the Asian investment conundrum
Turning to Asia, Pavilion highlights the conundrum facing large institutional investors. Since they are increasingly focused on reducing the number of fund manager relationships globally, they make larger investments into the biggest pan-Asian funds and end up with concentrated exposure to this end of the market. But it is often the niche strategies and smaller, country-focused funds providing exposure to the smaller end of the market that offer the potential for outsized returns. Therefore to enhance their overall returns, investors should consider the benefits of supplementing their core exposure to certain Pan-Asian funds with a satellite portfolio of select country-specific funds.
Impact of Trump on U.S. direct lending
Looking at private credit strategies, Pavilion explores the impact of the new Trump administration on direct lending activity in the United States. Far from having a negative impact, the expected rise in GPD growth should benefit the mid-market segment in particular, which is expected to increase its demand for flexible lending solutions. Private credit fund managers are better equipped to offer these solutions than traditional bank lenders. On the regulatory front, Pavilion notes that there is a limit to what Trump can do to change the status quo. But to maintain an attractive premium in this growing and competitive area, Pavilion believes it is critical to understand how private credit managers differ in their offerings.
Direct investments done the family office way
Pavilion charts the growing enthusiasm among family offices for direct investing as they seek to diversify their assets in order to prepare for family succession. Families’ interest in pursuing direct deals stems, in part, from their own entrepreneurial backgrounds and many have direct investments comprising between 25% and 50% of their overall alternatives allocation. While family offices often end up “doing it themselves” since the investment office is viewed as a cost centre instead of a wealth creator, as their direct investing exposure increases, Pavilion suggests getting quality advice to avoid resourcing challenges.
Managing allocations and the pressure to invest
According to Pavilion, the current up-market will present a major challenge to institutional private equity teams in 2017 as it leads to an increasing gap between target private equity allocation numbers and actual allocations. The cause is twofold: there are lags in private equity valuation moves in comparison to public market valuations, and the private market asset class self-liquidates (as companies are sold, cash is returned to the investor, and NAV is reduced). This may result in pressure to deploy capital at a velocity matching the trajectory of the public markets and private equity fund distributions. Current public market performance, along with increasing LP allocations to private equity, has made prudent investing that much more difficult.
About Pavilion Alternatives Group™
Pavilion Alternatives Group provides investment consulting services across alternative asset classes including private equity, private credit, real assets and hedge funds. Formed via the merger of Altius Associates (established 1998) and LP Capital Advisors (established 2004), Pavilion Alternatives Group has a successful track record of investing in a wide array of strategies across asset classes, industries and geographies, in various formats including commingled funds, secondaries, directs/co-investments and client-driven separately managed accounts, and throughout multiple economic and market cycles. The alternatives team features over 80 professionals serving clients globally from Europe, Asia, Australia and North America. It currently advises and provides customized solutions on more than $70 billion of alternative assets and $130 billion of committed capital for global clients including corporate and public pension plans, sovereign wealth funds, healthcare organizations, insurance plans, endowments, foundations and family offices. For more information, visit www.pavilioncorp.com/alternatives. Pavilion Alternatives Group is a trademark of Pavilion Financial Corporation, used under license by Pavilion Alternatives Group, LLC in the U.S., Pavilion Alternatives Group Limited in the UK, Pavilion Alternatives Group (Singapore) Pte Ltd., and Pavilion Advisory Group Ltd. in Canada.