UK Investors Increasing Private Equity Bets

February 24, 2003 ( - Thirty-eight percent of the United Kingdom's institutional investors expect to increase allocation to private equity in the next two years.

The expectation of extra private equity investments will push the average allocation for the asset class to 4% from the 3% seen currently.   Pointing to a bumpy market of the past three years, but more importantly the likelihood that such operating conditions are likely to prevail over the period, the 32 institutions surveyed responded positively to private equity’s capacity to generate absolute returns, according to data by AltAssets and the British Venture Capital Association .

On average, investors allocate roughly 40% of their private equity commitments to pan-European funds, 30% to the US, 20% to the UK, while continental European country-specific funds account for only about 5% of the portfolio.   The survey noted the importance of the US in the average portfolio, reflecting the size of its market and its far greater maturity than other parts of the globe.   Despite the downturn in the US venture market since 2000, its wealth of investment opportunities is still considered ahead of Europe, according to the report.

If It’s Not Broken….

The major reason citied for investing in private equity is the capacity to deliver superior risk-adjusted returns.   Additionally, institutional investors cited good non-financial reasons for investing in the asset class, such as boosting entrepreneurship and supporting regional development ambitions. However, these are widely considered to be an added bonus rather than a primary motive for investing.

The issue of absolute returns is highlighted by the survey’s revelation that investors will be targeting a higher premium over public equities from their private equity commitments over the next few years. The average premium at present is around 5% over public equities to allow for the additional risks of the asset class. The average, however, creeps up to 5.4% for the next five years.

Historically Speaking

Inquiring about previous sojourns into the private equity arena, respondents noteda historical average annual net return on their private equity investments of 19%. The investors continue to be bullish looking forward as well, with investors expecting returns over the next five years to average closer to 13%.   Over half of them described their returns experience as good or very good and the rest said they had been adequate, with none responding to a poor returns experience.   Additionally, those institutions that had been investing since before 1990 were even more positive about their experience.

Not surprisingly, investors that had entered the market in the late 1990s reported lower returns. They are suffering from making initial investments at the top of the market, since which time valuations have fallen substantially.

Obstacle Course

Some 59% of respondents said that lack of transparency was an important obstacle, making it the biggest grievance among investors. The response of investors to lack of transparency is generally to undertake exhaustive due diligence to ensure the information they get from funds makes sense or is in some way comparable with other firms. Where an investor does not feel they can make adequate sense of this information, either because of its complexity or the lack of a meaningful benchmark, they generally outsource the job to funds of funds or gatekeepers.

The lack of liquidity was also considered a significant obstacle. It has assumed even greater importance since the downturn in the market that followed the bursting of the technology bubble in 2000. Suddenly, a lot of investors found themselves holding venture portfolios that were worth much less than they had hoped but were extremely difficult to offload. There is an expanding secondaries market servicing the private equity industry but it remains complex and weighted in favor of the buyer. Other liquidity options, such as securitisation, are still in their infancy and have yet to provide an efficient way for investors to divest under-performing fund holdings.  

Looking Ahead

UK institutional investors expect a gentle increase in their allocation to private equity over the next two years despite predicting that returns will be weaker than their historical experience. The apparent contradiction is explained by the feeling that other asset classes will also under perform, thereby preserving private equity’s premium.

As for the defining trends within the asset class over the next five years, investors were unable to produce much of a consensus. Among the wide range of issues they said they expected some consolidation among private equity firms, a gradual improvement in transparency, more investor activism, and the emergence of more specialist funds.

Overall, the survey’s respondents predicted that average net annual returns from private equity investments would slip to around 13% over the next five years, compared with their historical experience of 19%.

However, the more experienced investors were a little more upbeat, forecasting an average return of 13.2%. The less experienced investors, presumably more heavily affected by the recent downturn, forecast returns would average a little below the returns forecast by the more experienced investors. It is the proximity of their forecasts that the survey says suggests a broad consensus about the health of the market.