Altius Highlights Eight Key Challenges Facing Private Markets in 2016
According to Altius Associates (“Altius”), one of the biggest global challenges facing investors in 2016 will be how private equity fund managers deal with the highest level of dry powder ever recorded while still delivering returns commensurate with private equity risk. This, together with making sense of the unprecedented number and complexity of private equity investment strategies now available, represents the two most significant eight challenges identified by Altius in its annual review: ‘Key Challenges Facing Private Markets in 2016.’
Europe – generating good returns
In Europe, Altius explores the challenge of generating good returns in today’s environment, where deal volumes are back to the level last witnessed in 2007/8. With distributions significantly outweighing drawdowns in 2015 and access to top performing funds becoming increasing difficult for investors, Altius warns investors to avoid being tempted to invest in funds that are not top tier in order to reach their desired allocation.
Asia – the haves and have-nots
Turning to Asia, Altius explores the growing bifurcation in fund raising, which is resulting in large amounts of capital placed with fewer proven winners, which are typically larger scale regional buyout and control-oriented funds. This trend has placed added pressure on the smaller end of the market, which, in Altius’ view, remains highly attractive and offers diversification and the potential for outsized returns.
Private Credit Strategies - impact of rate rises
Looking at private credit strategies, Altius considers what will happen to the sector when interest rates rise over 2016 and beyond. It explores the impact of rate rises on legacy portfolios, new issuances and the borrowing cost differential. While private credit will remain an important sub-asset class for investors, Altius believes that there could be a partial reallocation of capital away from the private credit illiquid space to more traditional fixed income strategies.
Regulatory Environment – impact on private equity
Altius examines the ongoing impact of regulation on the private equity industry, in particular the review by the European Securities and Markets Authority (ESMA) of the AIFMD marketing passport for non-EU entities. It also discusses the review carried out by the SEC into fees and expenses and the Fee Transparency Initiative conducted by the Institutional Limited Partners Association (ILPA). Altius believes these regulatory developments will result in cost implications, which may affect the small private equity managers lacking the resources to implement the changes.
Commodities –are we at the bottom?
Turning to commodities, Altius reviews how investors should respond to current pricing and how they may potentially generate outsized returns in the years ahead. It argues that the current situation, where prices of many commodities at or below the cost of much of the world’s production is unsustainable and believes that the end of the down cycle is near. As such, investors who are not exposed to the private energy and mining sectors may miss out on one of the most exciting and contrarian investment opportunities of the decade.
Secondaries – a buyer’s or seller’s market?
In the Secondaries market, Altius asks whether 2016 will be a good time to be a buyer, seller or both. In the firm’s view, the cases for buyers and sellers are equally compelling. Sellers are utilising the market’s abundant liquidity by seizing the opportunity to sell at attractive headline pricing while buyers continue to seek the traditional attributes of secondaries and are accessing the less efficient areas of the private equity market.
Commenting on the outlook for the private equity market in 2016, Brad Young Co-CEO, Head of Investments at Altius, said: “Recognising that private markets face a constantly evolving set of opportunities and challenges, Altius continues to identify and analyse specific areas of interest for clients and investors. We believe that the private market opportunity will remain robust in 2016 and we look forward to working with investors to build long-term value in their private market portfolios.”
Dry powder: causes, components, and concerns
Dr. William Charlton, Partner and Head of US at Altius Associates, said: “Not only is the current dry powder level continuing to increase, but it is more than 25% higher than the previous historic high of USD1.07 trillion attained at the end of 2008.”
“Private equity fund managers have been actively taking advantage of the favourable fund raising environment over the past few years while several have raised funds but not activated them. Thus, the private equity industry is in a somewhat unique situation in which private equity fund managers have a relatively easier time raising capital than they do in deploying it.”
Making investment decisions in an increasingly complex market
Catherine Mountjoy, Partner at Altius Associates, commented: “We’ve seen a substantial increase in the number of investment strategies being offered to institutional investors. No longer is there a simple option of choosing the best venture managers or the best leveraged buyout managers. Arguments can be made for the merits of these investment strategies and high quality managers find the approach that fits best with their team, capabilities, and past success.”
“Longer terms can provide a complementary investment to traditional fund structures and may help limit some of the reinvestment risks faced by investors. While all of these innovations can be helpful in providing solutions to certain investors, they also increase the complexity of investing in private equity and may cause conflicts for smaller or less informed investors. It is important for investors to consider how a fund manager’s other business may affect their investment and to know the questions to ask when conducting due diligence on a fund opportunity.”
The Great Divide: The bifurcation of Asian private equity fundraising
Peter Pfister, Partner and Head of Asia-Pacific at Altius Associates, said: “The recent divide in fundraising in Asian private equity has directed significant amounts of capital to the larger end of the market and into regional buyout and control-oriented funds.”
“This trend has placed added pressure on the smaller end of the market, which still remains an attractive part of the overall Asian private equity market and offers diversification and potential for outsized returns. Importantly, this part of the market should not be ignored, and many investors may find that local expertise is helpful in determining which fund managers to pursue within this space.”
Private credit: what happens when rates rise?
Elvire Perrin, Partner and Executive Director at Altius Associates, commented: “Given the Libor floor effect, the price of the debt for borrowers will not increase meaningfully until 2017. In 2017 and thereafter, rates above 1.5% could start having an impact, but the severity will depend on how levered the respective borrowers are. Given that debt levels used by fund managers in companies have been higher for sponsored direct lending strategies, we expect the probability of potential issues at the company level to be greater for this type of direct lending strategy than for non-sponsored ones. For new issuances, the cost of debt will increase mostly in line with interest rates increase when rates go above the Libor floors. This means that borrowers will need to spend more capital servicing their debt, likely reducing capital investment and level of innovation.”
The challenge of generating good returns in today’s environment (a Europe perspective)
Rhonda Ryan, Partner and Head of Europe, Middle East and Africa at Altius Associates, said: “Given the current favourable fundraising conditions, European investors are expected to commit significant amounts of capital to new funds. One reason behind investors keenness to deploy more capital is the large amount of distributions they have received over the past three years. Investor mentality such as this can be dangerous and caution should be exercised. In the rush to reach their target allocation investors should not be tempted to invest with fund managers that are not top tier.”
“Today access to some funds can be difficult for some investors as fund managers in the small and mid-market remain disciplined and don’t significantly increase fund sizes. For other funds, it may be that their track record is very strong or they are differentiated so that investor demand is significantly higher than their target fund size. For investors, it is important to remember to keep the threshold high and not be tempted to allocate to funds that they wouldn’t normally allocate to simply to reach their desired allocation.”
Challenges on the regulatory front for private equity
Rebecca Stiff, Compliance Manager at Altius Associates: “As with so much of the regulatory change that goes on, there will be a cost implication. Some feel that smaller private equity managers will suffer, as they don’t have the same resources available that the bigger players have to implement the changes.”
“There is no doubt that regulation will remain a hot topic for 2016. All parties from fund managers to investors, regulators and governments will continue to assess how best to implement the changes while continuing to grow and mature private equity markets. Protecting the interests of investors particularly large pension funds will also be at the forefront in all debates.”
Bottom of the commodity price cycle?
Jay Yoder, Partner and Head of Real Assets at Altius Associates, said: “It is impossible to accurately predict commodity prices. They have always been volatile and cyclical. Therefore, investors’ time is best spent sourcing quality private energy and mining managers who can add value to their assets and portfolio companies even if commodity prices do not rebound in the near future.”
“Certainly, the dramatic drop in commodity prices has created much dislocation, especially at companies or asset owners who over-extended, over-leveraged, and/or under-hedged. This has created a great opportunity for managers and investors to take advantage of the stress and distress and pick up assets at reasonable prices, at a time when commodity prices are likely near cyclical lows. It’s safe to say that we are much closer to the bottom of the commodity price cycle than we are to the top. Investors who are not exposed to the private energy and mining sectors may miss out on one of the most exciting and contrarian investment opportunities of this decade.”
Is today’s secondary market a buyer’s or a seller’s market?
Chason Beggerow, Partner at Altius Associates, commented: “Is now a good time to be a buyer or a seller in the secondary market? The answer is that it is… both, and it depends on an investor’s objectives and expectations. This answer is not an effort to avoid the question, but the large transaction volume in the market is a result of both buyers and sellers finding middle ground and being able to satisfy their respective goals.”
“We believe that the growth in transaction value over the past two years is a result of a type of equilibrium between buyers and sellers, where both have been able to utilise the secondary market to achieve their respective objectives. Sellers are utilising the market’s abundant liquidity by seizing the opportunity to sell at attractive headline pricing for portfolio management reasons – to reduce the number of managers or perhaps rebalance the portfolio towards an evolved strategy. Buyers continue to seek the traditional attributes of secondaries, are accessing less efficient areas of the private equity market, and continue to desire the favourable risk/return profile that secondaries have offered to investors over the past 15 years.”